10-Q 1 g89917e10vq.txt PROASSURANCE CORPORATION UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended JUNE 30, 2004 or ______ [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______ to ______. Commission file number 0-16533 ProAssurance Corporation ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 63-1261433 -------------------------------- ------------------------------------ (State or other jurisdiction of (IRS Employer Identification ID No.) incorporation of organization) 100 Brookwood Place, Birmingham, AL 35209 ----------------------------------------- ------------------------------------ (Address of principal executive offices) (Zip Code) (205) 877-4400 ------------------------------------------------------ (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes [X] No [ ]. As of June 30, 2004 there were 29,175,952 shares of the registrant's common stock outstanding. Page 1 of 39 PROASSURANCE CORPORATION FORM 10Q TABLE OF CONTENTS Part I - Financial Information Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets..................................... 3 Condensed Consolidated Statements of Changes in Capital................... 4 Condensed Consolidated Statements of Income............................... 5 Condensed Consolidated Statements of Comprehensive Income (Loss).......... 6 Condensed Consolidated Statements of Cash Flows........................... 7 Notes to Condensed Consolidated Financial Statements...................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................................................... 17 Item 3. Quantitative and Qualitative Disclosures about Market Risk................. 35 Item 4. Controls and Procedures.................................................... 36 Forward-Looking Statements......................................................... 37 Part II - Other Information Item 1. Legal Proceedings.......................................................... 38 Item 6. Exhibits and Reports on 8-K................................................ 38 Signature.......................................................................... 39
PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE DATA)
June 30 December 31 ------- ----------- 2004 2003 ---- ---- ASSETS Investments: Fixed maturities available for sale, at fair value $ 2,019,109 $ 1,790,778 Equity securities available for sale, at fair value 36,921 42,136 Equity securities, trading portfolio, at fair value 7,604 5,863 Real estate, net 18,077 17,262 Short-term investments 57,383 109,680 Other 41,608 38,247 Business owned life insurance 52,973 51,706 ----------- ----------- Total investments 2,233,675 2,055,672 Cash and cash equivalents 35,678 47,132 Premiums receivable 124,011 132,255 Receivable from reinsurers on unpaid losses and loss adjustment expenses 448,752 444,811 Prepaid reinsurance premiums 19,960 17,651 Deferred taxes 87,747 73,118 Other assets 119,855 108,713 ----------- ----------- $ 3,069,678 $ 2,879,352 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Policy liabilities and accruals: Reserve for losses and loss adjustment expenses $ 1,931,262 $ 1,814,584 Unearned premiums 299,218 290,134 Reinsurance premiums payable 77,225 68,510 ----------- ----------- Total policy liabilities 2,307,705 2,173,228 Other liabilities 57,906 55,030 Long-term debt 151,332 104,789 ----------- ----------- Total liabilities 2,516,943 2,333,047 Commitments and contingencies - - Stockholders' Equity: Common stock, par value $0.01 per share 100,000,000 shares authorized; 29,297,717 and 29,226,774 shares issued, respectively 293 292 Additional paid-in capital 313,821 312,030 Accumulated other comprehensive income, net of deferred tax expense of $3,919 and $18,537, respectively 7,275 34,422 Retained earnings 231,402 199,617 ----------- ----------- 552,791 546,361 Less treasury stock, at cost, 121,765 shares (56) (56) ----------- ----------- Total stockholders' equity 552,735 546,305 ----------- ----------- $ 3,069,678 $ 2,879,352 =========== ===========
See accompanying notes. 3 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN CAPITAL (UNAUDITED) (IN THOUSANDS)
Accumulated Other Comprehensive Retained Other Capital Total Income Earnings Accounts ----- ----------------- -------- ------------- Balance at December 31, 2003 $ 546,305 $ 34,422 $199,617 $312,266 Net income 31,785 - 31,785 - Change in fair value of securities available for sale, net of reclassification adjustments and deferred taxes (27,147) (27,147) - - Common stock issued for compensation 1,598 - - 1,598 Common stock options exercised 194 - - 194 --------- -------- -------- -------- Balance at June 30, 2004 $ 552,735 $ 7,275 $231,402 $314,058 ========= ======== ======== ========
Accumulated Other Comprehensive Retained Other Capital Total Income Earnings Accounts ----- ----------------- -------- ------------- Balance at December 31, 2002 $505,194 $35,545 $160,914 $308,735 Net income 15,141 - 15,141 - Change in fair value of securities available for sale, net of reclassification adjustments, and deferred taxes 15,669 15,669 - - Acquisition of minority interest 886 886 - - Common stock issued for compensation 1,038 - - 1,038 Common stock options exercised 280 - - 280 -------- ------- -------- -------- Balance at June 30, 2003 $538,208 $52,100 $176,055 $310,053 ======== ======= ======== ========
See accompanying notes. 4 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended June 30 June 30 ---------------------- ---------------------- 2004 2003 2004 2003 ---- ---- ---- ---- Revenues: Gross premiums written $ 163,756 $ 157,806 $ 382,483 $ 360,466 ========= ========= ========= ========= Net premiums written $ 144,253 $ 138,278 $ 339,715 $ 317,214 ========= ========= ========= ========= Premiums earned $ 184,870 $ 168,290 $ 373,398 $ 329,443 Premiums ceded (18,973) (20,606) (39,659) (43,563) --------- --------- --------- --------- Net premiums earned 165,897 147,684 333,739 285,880 Net investment income 20,683 17,844 40,534 35,092 Net realized investment gains (losses) 626 1,706 4,283 2,713 Other income 1,232 1,891 2,243 3,550 --------- --------- --------- --------- Total revenues 188,438 169,125 380,799 327,235 Expenses: Losses and loss adjustment expenses 161,710 170,556 314,383 316,202 Reinsurance recoveries (24,931) (39,256) (35,683) (59,854) --------- --------- --------- --------- Net losses and loss adjustment expenses 136,779 131,300 278,700 256,348 Underwriting, acquisition and insurance expenses 29,367 26,234 57,339 50,656 Interest expense 1,492 491 2,635 1,069 --------- --------- --------- --------- Total expenses 167,638 158,025 338,674 308,073 --------- --------- --------- --------- Income before income taxes and minority interest 20,800 11,100 42,125 19,162 Provision for income taxes: Current expense 2,328 5,581 7,654 6,139 Deferred expense (benefit) 2,668 (3,273) 2,686 (2,299) --------- --------- --------- --------- 4,996 2,308 10,340 3,840 --------- --------- --------- --------- Income before minority interest 15,804 8,792 31,785 15,322 Minority interest - - - 181 --------- --------- --------- --------- Net income $ 15,804 $ 8,792 $ 31,785 $ 15,141 ========= ========= ========= ========= Earnings per share: Basic $ 0.54 $ 0.30 $ 1.09 $ 0.52 ========= ========= ========= ========= Diluted $ 0.54 $ 0.30 $ 1.08 $ 0.52 ========= ========= ========= ========= Weighted average number of common shares outstanding: Basic 29,158 28,943 29,138 28,919 ========= ========= ========= ========= Diluted 29,423 29,154 29,392 29,079 ========= ========= ========= =========
See accompanying notes. 5 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED) (IN THOUSANDS)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 -------------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- COMPREHENSIVE INCOME (LOSS): Net income $ 15,804 $ 8,792 $ 31,785 $ 15,141 Change in fair value of securities available for sale, net of deferred taxes and minority interest (38,562) 16,895 (25,243) 17,243 Reclassification adjustment for realized investment (gains) losses included in income, net of deferred taxes 1 (1,033) (1,904) (1,574) -------- -------- -------- -------- Comprehensive income (loss) $(22,757) $ 24,654 $ 4,638 $ 30,810 ======== ======= ======== ========
See accompanying notes. 6 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
SIX MONTHS ENDED JUNE 30 ---------------------- 2004 2003 ---- ---- OPERATING ACTIVITIES Net cash provided (used) by operating activities $ 171,593 $ 139,999 INVESTING ACTIVITIES Purchases of available-for-sale securities: Fixed maturities (604,143) (552,233) Equity (538) (4,563) Proceeds from sale or maturity of available-for-sale securities: Fixed maturities 327,277 231,365 Equities 5,798 10,252 Purchase of other investments (3,137) (50,000) Net decrease in short-term investments 52,297 171,030 Other (5,527) (3,261) --------- --------- Net cash provided (used) by investing activities (227,973) (197,410) --------- --------- FINANCING ACTIVITIES Proceeds from issuance of long-term debt 46,395 - Debt issuance costs (1,491) - Purchase of minority interest - (33,304) Repayment of debt - (5,000) Other 22 - --------- --------- Net cash provided (used) by financing activities 44,926 (38,304) --------- --------- Increase (decrease) in cash and cash equivalents (11,454) (95,715) Cash and cash equivalents at beginning of period 47,132 143,306 --------- --------- Cash and cash equivalents at end of period $ 35,678 $ 47,591 ========= =========
See accompanying notes. 7 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements include the accounts of ProAssurance Corporation and its subsidiaries (collectively "ProAssurance"). The financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the six month period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes contained in ProAssurance's December 31, 2003 report on Form 10K. Stock-Based Compensation ProAssurance grants stock options to key employees under its various stock compensation plans adopted from time to time by the Board of Directors and approved by the stockholders ("the ProAssurance Plans"). ProAssurance accounts for such stock options under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations ("APB 25"). The following table illustrates the effect on net income (in thousands) and earnings per share as if ProAssurance had applied the fair value recognition provisions of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation, to options granted.
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 -------------------------- ---------------------- 2004 2003 2004 2003 ---- ---- ---- ---- Net income, as reported $ 15,804 $ 8,792 $ 31,785 $ 15,141 Add: Stock-based employee compensation expense recognized under APB 25 related to the exercise of options, net of related tax effects 84 62 148 62 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (365) (261) (624) (410) ---------- --------- ---------- --------- Pro forma net income $ 15,523 $ 8,593 $ 31,309 $ 14,793 ========== ========= ========== ========= Earnings per share: Basic -- as reported $ 0.54 $ 0.30 $ 1.09 $ 0.52 ========== ========= ========== ========= Basic -- pro forma $ 0.53 $ 0.30 $ 1.07 $ 0.51 ========== ========= ========== ========= Diluted -- as reported $ 0.54 $ 0.30 $ 1.08 $ 0.52 ========== ========= ========== ========= Diluted -- pro forma $ 0.53 $ 0.30 $ 1.07 $ 0.51 ========== ========= ========== =========
ProAssurance has outstanding 263,250 options with an exercise price of $33.28 per share that were granted under the ProAssurance Plans in March 2004. The estimated fair value of each option is $13.02, using the Black-Scholes option pricing model and the following model assumptions: risk-free interest rate of 3.4%; volatility of 0.34; expected life of 6 years; and dividend yield of 0%. 8 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 2. SEGMENT INFORMATION ProAssurance operates in the United States of America in two reportable industry segments: the professional liability insurance segment and the personal lines segment. The professional liability insurance segment principally provides professional liability insurance for providers of health care services, and to a limited extent, providers of legal services. The professional liability segment includes the operating results of three significant insurance companies: The Medical Assurance Company, Inc., ProNational Insurance Company, and Red Mountain Casualty Insurance Company, Inc. ProAssurance also writes professional liability insurance through Medical Assurance of West Virginia, Inc. The personal lines segment provides personal auto, homeowners, boat and umbrella coverages primarily to educational employees and their families through a single insurance company, MEEMIC Insurance Company. The accounting policies of the segments are consistent with those described in the Notes to the Consolidated Financial Statements included in ProAssurance's December 31, 2003 Annual Report on Form 10-K. Other than cash and marketable securities owned directly by the parent company, the identifiable assets of ProAssurance are attributable to the reportable operating segments. Except for investment income and investment gains or losses earned directly by the parent company and interest expense related to debt, all revenues and expenses of ProAssurance are attributable to the operating segments for purposes of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. Revenue is primarily from unaffiliated customers and the effects of transactions between segments have been eliminated. 9 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 2. SEGMENT INFORMATION (CONTINUED) The table below provides a reconciliation of segment information to total consolidated information (in thousands).
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 -------------------- ---------------- 2004 2003 2004 2003 ---- ---- ---- ---- Revenues: Professional liability lines $ 138,927 $ 123,691 $ 283,133 $ 238,565 Personal lines 48,771 45,427 96,170 88,601 Corporate investment income 740 7 1,496 69 --------- --------- --------- --------- Total $ 188,438 $ 169,125 $ 380,799 $ 327,235 ========= ========= ========= ========= Net income (loss): Professional liability lines $ 9,573 $ 3,101 $ 18,417 $ 4,906 Personal lines 6,702 6,006 14,086 10,885 Corporate (471) (315) (718) (650) --------- --------- --------- --------- Total $ 15,804 $ 8,792 $ 31,785 $ 15,141 ========= ========= ========= =========
JUNE 30 December 31 2004 2003 ------- ----------- Identifiable Assets: Professional liability lines $2,541,824 $2,413,043 Personal lines 457,642 431,264 Corporate 70,212 35,045 ---------- ---------- Total assets $3,069,678 $2,879,352 ========== ==========
10 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 3. INVESTMENTS The amortized cost of available for sale fixed maturities and equity securities is $2.045 billion and $1.780 billion at June 30, 2004 and December 31, 2003, respectively. Proceeds from sales of fixed maturities and equity securities during the six month period ended June 30, 2004 and 2003 are $219.2 million and $155.6 million, respectively. Net realized investment gains (losses) are comprised of the following (in thousands):
SIX MONTHS ENDED JUNE 30 --------------------- 2004 2003 ---- ---- Gross realized gains $ 3,539 $ 4,995 Gross realized (losses) (602) (1,960) Other than temporary impairment (losses) -- (322) Trading portfolio gains (losses) 1,346 -- ------- ------- Net realized investment gains (losses) $ 4,283 $ 2,713 ======= =======
4. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES ProAssurance establishes its reserve for losses and loss adjustment expenses based on individual claims and actuarially determined estimates of future losses based on ProAssurance's past loss experience, available industry data and projections as to future claims frequency, severity, inflationary trends and settlement patterns. ProAssurance believes that the methods it uses to establish reserves are reasonable and appropriate. However, estimating reserves, especially professional liability reserves, is a complex process. Claims may be resolved over an extended period of time, often five years or more, and are frequently subject to litigation and the inherent risks of litigation. Estimating losses for liability claims requires ProAssurance to make and revise judgments and assessments regarding multiple uncertainties over an extended period of time. As a result, reserve estimates may vary significantly from the eventual outcome. The assumptions used in establishing ProAssurance's reserves are regularly reviewed and updated by management as new data becomes available. Any adjustments necessary are reflected in then current operations. ProAssurance's management believes the unearned premiums under contracts together with the related anticipated investment income to be earned are adequate to discharge the related contract liabilities. 5. DEFERRED POLICY ACQUISITION COSTS Costs that vary with and are directly related to the production of new and renewal premiums (primarily premium taxes, commissions and underwriting salaries) are deferred to the extent they are recoverable against unearned premiums and are amortized as related premiums are earned. Amortization of deferred policy acquisition costs, net of ceding commissions earned, amounted to approximately $30.9 million and $25.9 million for the six months ended June 30, 2004 and 2003, respectively. 6. INCOME TAXES The provision for income taxes is different from that which would be obtained by applying the statutory Federal income tax rate to income before taxes primarily because a portion of ProAssurance's investment income is tax-exempt. 11 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 7. LONG-TERM DEBT Outstanding long-term debt, as of June 30, 2004 and December 31, 2003, consisted of the following (in thousands):
JUNE 30 December 31 2004 2003 ---- ---- Convertible debentures due June 30, 2023, unsecured and bearing a fixed interest rate of 3.9%, net of unamortized original issuer's discounts of $2,663 and $2,811 at June 30, 2004 and December 31, 2003, respectively. $104,937 $ 104,789 Trust Preferred subordinated debentures, unsecured, and bearing floating interest rate, adjustable quarterly, at three-month LIBOR plus 3.85% Due June 30, 2004 Rate --- ------------------ April 29, 2034 5.09% 13,403 -- May 12, 2034 5.09% 10,310 -- May 12, 2034 5.09% 22,682 -- --------- --------- $ 151,332 $ 104,789 ========= =========
Convertible Debentures due June 30, 2023 In July 2003 ProAssurance issued convertible debentures having a face value of $107.6 million (the Debentures). The Debentures are unsecured obligations that rank equally in right of payment with all other existing and future unsecured and unsubordinated obligations of the parent company, but are effectively subordinated to the indebtedness and other liabilities of ProAssurance's subsidiaries, including insurance policy-related liabilities. The Debentures are convertible into shares of common stock of ProAssurance. Holders may convert the Debentures at any time prior to stated maturity from and after the date of the following events: if ProAssurance calls the Debentures for redemption; upon the occurrence of certain corporate transactions, including a change of control; or if the sale price of ProAssurance's common stock exceeds 120% of the then conversion price for a specified period as defined in the Indenture. The conversion price was initially established at $41.83 per common share or 23.9037 shares per $1,000 principal amount of the Debentures surrendered for conversion, and may be adjusted as a result of certain corporate transactions with respect to our common stock. ProAssurance has the right to deliver cash in lieu of common stock for all or a portion of any conversion shares. Holders of the Debentures may require ProAssurance to repurchase all or a portion of the holder's Debentures on June 30, 2008, June 30, 2013 and June 30, 2018 at a purchase price equal to the principal amount of the Debentures plus accrued and unpaid interest, including contingent interest, if any, to the date of repurchase. ProAssurance may choose to pay the purchase price in cash, shares of common stock, or a combination of cash and shares of common stock. Shares of common stock will be valued at 97.5 % of the average sale price of the stock for a specified period prior to the redemption. If there is an event of default under the Debentures, the principal amount of the Debentures, plus accrued interest, including contingent interest, if any, may be declared immediately due and payable. These amounts automatically become due and payable if an event of default relating to certain events of bankruptcy, insolvency or reorganization occurs. The Debentures do not require ProAssurance to maintain minimum financial covenants and do not limit the payment of dividends. ProAssurance may redeem some or all of the Debentures for cash on or after July 7, 2008 with proper notice to the holders of the Debentures. 12 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 Note 11 of ProAssurance's December 31, 2003 Notes to the Consolidated Financial statements includes additional information regarding the terms of the Convertible Debentures. Subordinated Debentures In April and May 2004, ProAssurance formed two business trusts, ProAssurance Capital Trust I and ProAssurance Capital Trust II (the Trusts), as the holder of all voting securities issued by the trusts, for the sole purpose of issuing, in private placement transactions, $45.0 million of trust preferred securities (TPS) and using the proceeds thereof, together with the equity proceeds received from ProAssurance in the initial formation of the Trusts, to purchase subordinated debentures issued by ProAssurance. The only assets of the Trusts are $46.4 million variable rate ProAssurance subordinated debentures (Subordinated Debentures). The terms and maturities of the Subordinated Debentures mirror those of the TPS. The Trusts will meet the obligations of the TPS with the interest and principal ProAssurance pays to the Trust on the Subordinated Debentures. ProAssurance is not the primary beneficiary of the Trusts, and, therefore, in accordance with the provisions of FIN 46, the Trusts are not consolidated by ProAssurance. ProAssurance's equity investment in the Trusts is included in other assets and the Subordinated Debentures payable to the Trusts are included as long-term debt in the accompanying Consolidated Balance Sheets. The Subordinated Debentures and the TPS have the same maturities and other applicable terms and features. They are uncollateralized and bear a floating interest rate equal to the three-month LIBOR plus 3.85%, adjustable and payable quarterly, with a maximum rate within the first five years of 12.5%. ProAssurance has the right under the Subordinated Debentures to extend interest payment periods up to twenty consecutive quarterly periods, and as a consequence, dividends on the preferred securities may be deferred (but will continue to accumulate, together with additional dividends on any accumulated but unpaid dividends at the dividend rate) during any such extended interest payment periods. ProAssurance may not pay any shareholder dividends during any extended interest payment period or at any time ProAssurance is in default under the Subordinated Debenture. The Subordinated Debentures and the TPS have stated maturities of thirty years but may be redeemed at any time after five years. The Subordinated Debentures do not require ProAssurance to maintain minimum financial covenants. ProAssurance received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $44.9 million. Issue costs of $1.5 million were capitalized and are being amortized over five years as a component of amortization expense. The proceeds are available for general corporate purposes, including providing statutory capital for ProAssurance's professional liability insurance subsidiaries. ProAssurance has guaranteed that amounts paid to the Trusts related to the Subordinated Debentures will be remitted to the holders of the TPS. The guarantee, when taken together with the obligations of ProAssurance under the Subordinated Debentures, the Indenture pursuant to which the Subordinated Debentures were issued, and the related trust agreements (including its obligations to pay related trust cost, fees, expenses, debts and other obligations of the Trusts other than with respect to the TPS and the common securities of the Trusts), provide a full and unconditional guarantee of amounts due on the TPS. The amounts guaranteed are not expected to at any time exceed the obligations of the Subordinated Debentures, and no additional liability has been recorded related to the TPS or the guarantee. 13 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 8. STOCKHOLDERS' EQUITY At June 30, 2004 ProAssurance had 100 million shares of authorized common stock and 50 million shares of authorized preferred stock. The Board of Directors has the authorization to determine the provisions for the issuance of shares of the preferred stock, including the number of shares to be issued and the designations, powers, preferences and rights and the qualifications, limitations or restrictions of such shares. At June 30, 2004 the Board of Directors had not authorized the issuance of any preferred stock nor determined any provisions for the preferred stock. 9. COMMITMENTS AND CONTINGENCIES ProAssurance is involved in various legal actions arising primarily from claims related to insurance policies and claims handling, including but not limited to claims asserted by policyholders. The legal actions arising from these claims have been considered by ProAssurance in establishing its reserves. While the outcome of all legal actions is not presently determinable, ProAssurance's management is of the opinion, based on consultation with legal counsel, that the settlement of these actions will not have a material adverse effect on ProAssurance's financial position. However, to the extent that the cost of resolving these actions exceeds the corresponding reserves, the legal actions could have a material effect on ProAssurance's results of operations for the period in which any such action is resolved. 10. MINORITY INTEREST On January 29, 2003 ProAssurance's indirect subsidiary, MEEMIC Holdings, Inc. (MEEMIC Holdings) repurchased all of the outstanding shares of its common stock that were not owned by ProAssurance's subsidiary, ProNational Insurance Company. MEEMIC Holdings used its internal funds in the approximate amount of $34.1 million to acquire 1,062,298 shares of its common stock, to pay for outstanding options representing 120,000 shares, and to pay the expenses of the transaction. The funds were derived from MEEMIC Holdings' cash and investment resources. As a result of the transaction MEEMIC Holdings became a wholly-owned indirect subsidiary of ProAssurance. Minority interest shown in the 2003 Consolidated Statements of Income is the income attributable (16%) to the MEEMIC Holdings minority interest for the period from January 1, 2003 to January 29, 2003. MEEMIC Holdings is the 100% owner of MEEMIC Insurance Company. 14 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 11. EARNINGS PER SHARE The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations (amounts are in thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 ------------------ ---------------- 2004 2003 2004 2003 ---- ---- ---- ---- Numerator - Basic and Diluted: Net income $15,804 $ 8,792 $31,785 $15,141 ------- ------- ------- ------- Denominator - Basic: Weighted average number of common shares outstanding 29,158 28,943 29,138 28,919 ======= ======= ======= ======= Denominator - Diluted: Weighted average number of common shares outstanding 29,158 28,943 29,138 28,919 Assumed conversion of dilutive stock options and awards 265 211 254 160 ------- ------- ------- ------- Diluted weighted average equivalent shares 29,423 29,154 29,392 29,079 ======= ======= ======= ======= Earnings per share: Basic $ 0.54 $ 0.30 $ 1.09 $ 0.52 ======= ======= ======= ======= Diluted $ 0.54 $ 0.30 $ 1.08 $ 0.52 ======= ======= ======= =======
In accordance with SFAS 128 "Earnings per Share", the diluted weighted average number of shares outstanding includes an incremental adjustment for the assumed conversion of dilutive stock options. Stock options are considered dilutive stock options if the assumed conversion of the options, using the treasury stock method as specified by SFAS 128, produces an increased number of outstanding shares. Typically, options are not dilutive when the strike price of the option is very close to or below the average share price during the quarter. For the periods ending June 30, 2004 and 2003, approximately 100 and 3,000 employee stock options, respectively, were not considered to be dilutive because the strike price of the options was below the average ProAssurance share price during the quarter. 15 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 12. VARIABLE INTEREST ENTITIES ProAssurance has adopted the provisions of Financial Accounting Standards Board Interpretation No. 46 "Consolidation of Variable Interest Entities" (FIN 46); however, the adoption has no significant effect on the financial statements of ProAssurance. ProAssurance holds passive investments in four limited partnerships/limited liability companies that are considered to be variable interest entities (VIE's) under FIN 46 guidance. ProAssurance is not the primary beneficiary relative to these entities and is not required to consolidate the entities under FIN 46. These investments are included in Other Investments and total $39.1 million at June 30, 2004 and $37.1 million at December 31, 2003. The entities are all non-public investment pools formed for the purpose of achieving diversified equity and debt returns. For three of the entities, ProAssurance's investment represents an ownership interest that is less than 10%. ProAssurance's investment in the remaining entity represents an ownership interest of about 33%. ProAssurance's involvement with two of the entities originated in 2000; one in 2002, and one in 2003. ProAssurance's maximum loss exposure relative to each of the entities is limited to the carrying value of ProAssurance's investment in the entity. ProAssurance also holds all the voting securities issued by two trusts, ProAssurance Capital Trust I and ProAssurance Capital Trust II, that are considered to be VIE's. See Note 7. The Trusts are not consolidated because ProAssurance is not the primary beneficiary of either trust. Accordingly, within the accompanying June 30, 2004 condensed consolidated balance sheet, the Subordinated Debentures issued by ProAssurance to the Trusts are included in long-term debt, and ProAssurance's $1.4 million equity investment in the Trusts is included in other assets. 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements appearing elsewhere in this report. Throughout the discussion, references to ProAssurance, "we," "us" and "our" refers to ProAssurance Corporation and its subsidiaries. The discussion contains certain forward-looking information that involves risks and uncertainties. As discussed under "Forward-Looking Statements," our actual financial condition and operating results could differ significantly from these forward-looking statements. CRITICAL ACCOUNTING POLICIES Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Preparation of these financial statements requires us to make estimates and assumptions in certain circumstances that affect the amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected from time-to-time by the need to make accounting adjustments reflecting changes in these estimates and assumptions. Management considers an accounting estimate to be critical if: - it requires assumptions to be made based on data that was not final at the time the estimate was made; and - changes in the estimate, or the selection of a different estimate, could have a material effect on our consolidated results of operations or financial condition. We believe the following policies used in the preparation of the consolidated financial statements are the most sensitive to estimates and judgments. RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES (RESERVE FOR LOSSES) Our reserve for losses represents our estimate of the future amounts necessary to pay claims and expenses associated with investigation and settlement of claims. These estimates consist of case reserves and bulk reserves. Case reserves are estimates of future losses and loss adjustment expenses (losses) for reported claims and are established by our claims departments. Bulk reserves, which include a provision for insured events that have occurred but have not been reported to us as well as development on reported claims, are the difference between (i) the sum of case reserves and paid losses and (ii) an actuarially determined estimate of the total losses necessary for the ultimate settlement of all reported claims and incurred but not reported claims, including amounts already paid. The estimates take into consideration our past loss experience, available industry data and projections as to future claims frequency, severity, inflationary trends and settlement patterns. Independent actuaries review our reserve for losses each year and prepare reports that include recommendations as to the level of the reserve. We consider these recommendations as well as other factors, such as known, anticipated or estimated changes in frequency and severity of claims and loss retention levels and premium rates, in establishing the amount of our reserve for losses. Estimating casualty insurance reserves, and particularly professional liability reserves, is a complex process. These claims are typically resolved over an extended period of time, often five years or more, and estimating loss costs for these claims requires multiple judgments involving many uncertainties made over an extended period of time. Our reserve estimates may vary significantly from the eventual outcome. The assumptions used in establishing our reserve are regularly reviewed and updated by management as new data becomes available. Any adjustments necessary are reflected in then current operations. Due to the size of our reserve, even a small percentage adjustment to these estimates could have a material effect on our results of operations for the period in which the change is made. 17 REINSURANCE Our receivable from reinsurers represents our estimate of the amount of our future loss payments that will be recoverable from our reinsurers. These estimates are based upon our estimates of the ultimate losses that we expect to incur and the portion of those losses that we expect to be allocable to reinsurers based upon the terms of our reinsurance agreements. We also estimate premiums ceded under reinsurance agreements wherein the premium due to the reinsurer, subject to certain maximums and minimums, is a percentage of the losses reimbursed under the agreement. Given the uncertainty of the ultimate amounts of our losses, these estimates may vary significantly from the eventual outcome. Our estimates of the amounts receivable from and due to reinsurers are regularly reviewed and updated by management as new data becomes available. Our assessment of the collectibility of the recorded amounts receivable from reinsurers is based upon public financial statements and rating agency data as well as our experience in collecting amounts billed to reinsurers. Any adjustments necessary are reflected in then current operations. Due to the size of our receivable from reinsurers, even a small percentage adjustment to these estimates could have a material effect on our results of operations for the period in which the change is made. At June 30, 2004, we considered all of our receivable from reinsurers to be collectible. INVESTMENTS We consider our fixed maturity securities as available-for-sale and our equity securities as either available-for-sale or trading portfolio securities. Our available-for-sale securities are available to be sold in response to a number of issues, including our liquidity needs, changes in market interest rates and investment management strategies, among others. Available-for-sale securities are recorded at fair value. The related unrealized gains and losses, net of income tax effects, are excluded from net income and reported as a component of stockholders' equity. We evaluate the securities in our available-for-sale investment portfolio on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other-than-temporary declines. Some of the factors we consider in the evaluation of our investments are: - the extent to which the market value of the security is less than its cost basis; - the length of time for which the market value of the security has been less than its cost basis; - the financial condition and near-term prospects of the security's issuer, taking into consideration the economic prospects of the issuers' industry and geographical region, to the extent that information is publicly available; and - our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. A decline in the fair value of an available-for-sale security below cost that we judge to be other-than-temporary is recorded as a net realized investment loss in the current period statement of income and reduces the cost basis of the security. In subsequent periods, we base any measurement of gain or loss or decline in value upon the adjusted cost basis of the security. Since January 1, 2003, we have designated certain of our equity security purchases as trading portfolio securities. A trading portfolio is carried at fair value with the holding gains and losses included in the current period income statement as a component of net realized investment gains (losses). Therefore, current period income reflects both positive and negative changes in the market value of these securities. 18 LIQUIDITY AND CAPITAL RESOURCES AND FINANCIAL CONDITION Our primary need for liquid funds is to pay losses and operating expenses in the ordinary course of business and to meet our debt service requirements. Our operating activities provided positive cash flow of $172 million for the six months ended June 30, 2004 as compared to $140 million for the six months ended June 30, 2003. As in the prior year, our operating cash flows are primarily derived from net investment income received and from the excess of premiums collected over paid net losses and operating costs. Timing delays exist between the collection of premiums and the payment of losses, particularly so with regard to our professional liability premiums. In periods of business growth, premium collections generally exceed losses paid. Premium growth is the primary reason for the 2004 increase in cash flow from operating activities. We believe that premium adequacy is critical to our long-term liquidity. We continually review rates, particularly professional liability rates, and submit requests for rate increases to state insurance departments as we consider necessary to maintain rate adequacy. We achieved average overall rate increases of 18% during the first half of 2004 and 28% during each of the years ended December 31, 2003 and 2002. We are unable to predict whether we will continue to receive approval for our rate filings. We held cash and cash equivalents of approximately $35.7 million at June 30, 2004 as compared to $47.1 million at December 31, 2003. We transfer most of the cash generated from operations into our investment portfolio, primarily into investment grade fixed maturity securities. Our total investments increased from $2.056 billion at December 31, 2003 to $2.234 billion at June 30, 2004, due to the investment of funds generated from operating activities and the investment of $44.9 million in net proceeds from the sale of trust preferred securities. Fixed maturity securities comprise more than 87% of total investments at June 30, 2004 and December 31, 2003. At June 30, 2004 fixed maturity securities had a fair value of $2.019 billion as compared to $1.791 billion at December 31, 2003. The increase since December 31, 2003 reflects the investment of cash generated from operations, the transfer of funds from short-term investments and cash and cash equivalents and the investment of funds obtained from the sale of trust preferred securities in 2004, offset by a decline in unrealized gains. Our investment in short-term securities decreased by $52.3 million at June 30, 2004 as compared to December 31, 2003 primarily because funds were transferred to higher yielding fixed maturity investments. Substantially all of our fixed maturities are either United States government or agency obligations or investment grade securities as determined by national rating agencies. The fixed maturity securities in our investment portfolio had a dollar weighted average rating of "AA," at June 30, 2004. Our fixed maturities are purchased with the intent to hold such investments to maturity; however, we consider these securities as available-for-sale because we may dispose of the securities prior to their maturity in order to meet the Company's then current objectives. Our investment policies implement an asset allocation that uses length to maturity as one method of managing our long-term rate of return. The weighted average modified duration of our fixed maturity securities at June 30, 2004 is 3.8 years. We regularly evaluate the interest rate environment, and adjust our duration targets to maximize investment yield. Changes in market interest rate levels generally affect our net income to the extent that reinvestment yields are different than the original yields on maturing securities. Additionally, changes in market interest rates may also affect the fair value of our fixed maturity securities. Net before tax unrealized gains related to our available-for-sale securities decreased by $41.8 million at June 30, 2004 as compared to December 31, 2003 primarily because average bond yields increased and prices declined during 2004. For a more detailed discussion of the effect of changes in interest rates on our investment portfolio see "Item 7A Quantitative and Qualitative Disclosures about Market Risk." We use reinsurance to provide capacity to write large limits of liability, to reduce losses of a catastrophic nature and to stabilize underwriting results in those years in which such losses occur. The purchase of reinsurance does not relieve us from the ultimate risk on our policies, but it does provide reimbursement from the reinsurer for certain losses paid by us. The effective transfer of risk is dependent on the credit-worthiness of the reinsurer. We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance brokers assist us in the analysis of the credit quality of our reinsurers. We base our reinsurance buying 19 decisions on an evaluation of the then current financial strength and stability of prospective reinsurers. However, the financial strength of our reinsurers, and their corresponding ability to pay us, may change in the future due to forces or events we cannot control or anticipate. We have not experienced any difficulties in collecting amounts due from reinsurers due to the financial condition of the reinsurer. Should future events lead us to believe that any reinsurer is unable to meet its obligations to us, adjustments to the amounts recoverable would be reflected in the results of current operations. As our premiums have grown, so has our need for capital to support our insurance operations and maintain our ratings. We have experienced significant growth with respect to our professional liability premiums and expect continued growth throughout the remainder of 2004. This growth has primarily come as a result of increased prices but is also a result of reduced competition in the professional liability market. In recent years, we have taken actions to obtain additional capital for general corporate purposes, including supporting growth by our insurance subsidiaries. Since late 2002 we have contributed approximately $56.0 million to the capital of our professional liability insurance subsidiaries to support the growth in insurance operations. In late 2002, we raised $46.5 million through the sale of our common stock in an underwritten public offering. In early July 2003 we received $104.6 million from the issuance of twenty-year 3.9% Convertible Debentures, due June 2023, having a face value of $107.6 million. We utilized $67.5 million of the net proceeds to repay our term loan and did not replace the related line of credit. In April and May 2004, we formed two business trusts (the Trusts) as the holder of all voting securities issued by the trusts; the sole purpose of the Trusts being to issue, in private placement transactions, $45.0 million of trust preferred securities (TPS) and use the proceeds thereof, together with the equity proceeds that we contributed upon formation of the Trusts, to purchase our $46.4 million variable rate subordinated debentures (Subordinated Debentures), which are the only assets of the trusts. The terms and maturities of the Subordinated Debentures mirror those of the TPS. The Trust will meet the obligations of the TPS with the interest and principal we pay to the Trust related to the Subordinated Debentures. Both the Subordinated Debentures and the TPS mature thirty years from issuance, are redeemable at our option any time after five years, and bear interest, payable quarterly, at a variable rate based on the London Interbank Offered Rate ("LIBOR") plus 3.85%. See Note 7 of the Notes to the Condensed Consolidated Financial statements included herein for a more detailed description of the subordinated debentures. We received net proceeds from the trust preferred transactions, after commissions paid to placement agents, of $44.9 million. The proceeds are available for general corporate purposes, including providing statutory capital for our professional liability insurance subsidiaries. We filed a universal shelf registration statement with the Securities and Exchange Commission (SEC) that would allow us to offer from time-to-time up to $250 million in common stock, preferred stock or debt securities. We may sell any class of the registered securities or combinations thereof in one or more separate offerings at a total price up to the amount registered with the amount, price and terms of the securities sold in each offering to be determined at the time of sale. We have no present commitments to sell securities under the shelf registration. Our ability to sell any of these securities will depend in part on our ability to continue profitable operations and maintain the credit ratings assigned to us by A.M. Best and Standard & Poor's. Any sale would require us to file a supplemental prospectus that specifies the terms of the securities to be sold. If securities are sold, we expect that the net proceeds will be used for general corporate purposes, which may include contributions to the capital and surplus of our subsidiaries, the repurchase of outstanding debt securities, or the repayment of other indebtedness. The registration statement was filed on February 9, 2004. We currently do not have any specific plans to sell securities under the statement. 20 OFF BALANCE SHEET ARRANGEMENTS AND GUARANTEES We are not the primary beneficiary of either of the Trusts created in the TPS transactions and therefore, in accordance with the provisions of FIN 46, the Trusts are not included in our consolidated financial statements. The Subordinated Debentures are payable to the Trusts and are included in our condensed consolidated financial statements as long term debt. We have issued guarantees that amounts paid to the Trusts related to the Subordinated Debentures will subsequently be remitted to the holders of the TPS. The amounts guaranteed are not expected to at any time exceed our obligations under the Subordinated Debentures, and we have not recorded any additional liability related to the TPS or the guarantee. OVERVIEW ProAssurance Corporation is an insurance holding company and its operating results are almost entirely derived from the operations of its insurance subsidiaries. ProAssurance operates in two industry segments: professional liability insurance and personal lines insurance. The professional liability segment is our largest segment, representing over 73% of 2004 year-to- date gross written premiums and approximately 83% of total assets at June 30, 2004. This segment principally provides liability insurance for providers of health care services in the South and Midwest, and, to a limited extent, providers of legal services in the Midwest. The principal operating insurance subsidiaries of this segment are: The Medical Assurance Company, Inc., ProNational Insurance Company and Red Mountain Casualty Insurance Company, Inc. We also write professional liability insurance through Medical Assurance of West Virginia, Inc. Our personal lines segment provides personal property and casualty insurance primarily to members of the educational community and their families in the state of Michigan. Our personal lines segment includes the operations of a single insurance company, MEEMIC Insurance Company (MEEMIC). Revenues and expenses are attributable to the operating segments with the exception of corporate income, which consists of investment income earned directly by the parent holding company and interest expense related to long-term debt held by the parent. Operating results by segment for the three and six month periods ended June 30, 2004 and 2003 are summarized below.
Three Months Ended Six Months Ended June 30 June 30 ------------------ ----------------- Increase Increase 2004 2003 (Decrease) 2004 2003 (Decrease) ---- ---- ---------- ---- ---- ---------- $ In thousands Income before income taxes and minority interest: Professional Liability Segment $ 11,868 $ 2,940 $ 8,928 $ 22,724 $ 4,265 $ 18,459 Personal Lines Segment 9,684 8,644 1,040 20,540 15,897 4,643 Corporate (unallocated to segments) (752) (484) (268) (1,139) (1,000) (139) -------- -------- ------- -------- -------- -------- Consolidated $ 20,800 $ 11,100 $ 9,700 $ 42,125 $ 19,162 $ 22,963 ======== ======== ======= ======== ======== ========
21 Our professional liability segment operates in a challenging environment. Beginning in 2000, virtually all providers of medical professional liability began to recognize adverse trends in claim severity, causing increased estimates of current and prior losses. Throughout the industry, premiums previously considered adequate to cover expected losses and provide some profit were found to be inadequate. We began to address these trends in 2000 by seeking to increase premium rates in order to more closely align revenues with expected losses. We have implemented rate increases in all states, even when this has resulted in non-renewal of business. We have been more selective in our underwriting criteria and have elected to not-renew business that we did not expect to write profitably. At the same time, we have also worked to contain losses and to improve operating efficiencies. Our ability to successfully implement premium rate increases has been the most significant factor in improving the underwriting results of this segment. Investment income is a substantial revenue source for the professional liability segment because, on average, premiums are collected several years before the related losses are paid. Additionally, we consider realized capital gains to be a significant part of our investment strategy and realized capital gains and losses can have a substantial effect on our revenues. Prevailing market interest rates have been at historically low levels in recent years reducing our investment income. The decline in investment income somewhat offsets any improvement that results from premium increases. In an attempt to mitigate that risk, we take interest rates into account as we develop our rates. Our personal lines segment operates in a highly competitive environment dominated by larger insurance organizations. We must provide a high level of service while operating efficiently in order to competitively price our products and obtain positive financial results. Investment income is a less significant component of revenues for the personal lines segment than for the professional lines segment because the length of time between the collection of premiums and the settlement of claims is generally short; approximately 75% of claims are paid within one year after the claim is filed. Investment income has increased only slightly because increases in the investment portfolio have been offset by declines in yields. Losses are the largest component of expense for both the professional liability segment and the personal lines segment. Our consolidated net loss ratio (the income statement line "Net losses and loss adjustment expenses" divided by the income statement line "Net premiums earned") for the six months ended June 30, 2004 is 83.5%, reflecting a net loss ratio of 91.3% for the professional liability segment and 62.2% for the personal lines segment. As discussed in critical accounting policies, net losses in any period reflects our estimate of net losses related to the premiums earned in that period as well as any changes to our estimates of the reserve required for net losses of prior periods. 22 RESULTS OF OPERATIONS-THREE AND SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE AND SIX MONTHS ENDED JUNE 30, 2003 For the three month period ended June 30, 2004, our consolidated net income is $15.8 million, or $0.54 per diluted share as compared to $8.8 million or $0.30 per diluted share for the same period in 2003. For the six month period ended June 30, 2004, our consolidated net income is $31.8 million, or $1.08 per diluted share, as compared to $15.1 million or $0.52 per diluted share for the same period in 2003. Results for each period are summarized in the table below.
Three Months Ended Six Months Ended June 30 June 30 -------------------- Increase --------------------- Increase 2004 2003 (Decrease) 2004 2003 (Decrease) ---- ---- ---------- ---- ---- ---------- $ In thousands Revenues: Gross premiums written $163,756 $157,806 $ 5,950 $382,483 $360,466 $ 22,017 ======== ======== ======== ======== ======== ======== Net premiums written $144,253 $138,278 $ 5,975 $339,715 $317,214 $ 22,501 ======== ======== ======== ======== ======== ======== Net premiums earned 165,897 147,684 18,213 333,739 285,880 47,859 Net investment income 20,683 17,844 2,839 40,534 35,092 5,442 Net realized investment gains (losses) 626 1,706 (1,080) 4,283 2,713 1,570 Other income 1,232 1,891 (659) 2,243 3,550 (1,307) -------- -------- -------- -------- -------- -------- Total revenues 188,438 169,125 19,313 380,799 327,235 53,564 -------- -------- -------- -------- -------- -------- Expenses: Net losses and loss adjustment expenses 136,779 131,300 5,479 278,700 256,348 22,352 Underwriting, acquisition and insurance expenses 29,367 26,234 3,133 57,339 50,656 6,683 Interest expense 1,492 491 1,001 2,635 1,069 1,566 -------- -------- -------- -------- -------- -------- Total expenses 167,638 158,025 9,613 338,674 308,073 30,601 -------- -------- -------- -------- -------- -------- Income before income taxes 20,800 11,100 9,700 42,125 19,162 22,963 Income taxes (benefit) 4,996 2,308 2,688 10,340 3,840 6,500 -------- -------- -------- -------- -------- -------- Income before minority interest 15,804 8,792 7,012 31,785 $ 15,322 16,463 Less: Minority interest - - - - 181 181 -------- -------- -------- -------- -------- -------- Net income $ 15,804 $ 8,792 $ 7,012 $ 31,785 15,141 $ 16,644 ======== ======== ======== ======== ======== ======== Net loss ratio * 82.4% 88.9% (6.5%) 83.5% 89.7% (6.2%) Underwriting expense ratio * 17.7% 17.8% (0.1%) 17.2% 17.7% (0.5%) -------- -------- -------- -------- -------- -------- Combined ratio 100.1% 106.7% (6.6%) 100.7% 107.4% (6.7%) Less: Investment income ratio * 12.5% 12.1% 0.4% 12.1% 12.3% (0.2%) -------- -------- -------- -------- -------- -------- Operating ratio 87.6% 94.6% (7.0%) 88.6% 95.1% (6.5%) ======== ======== ======== ======== ======== ========
* Ratios shown are expressed as a ratio of net premiums earned.
JUNE 30 December 31 2004 2003 ---- ---- $ In thousands Total assets $3,069,678 $2,879,352 ========== ========== Net reserve for losses $1,482,509 $1,369,773 ========== ==========
23 The operating results of each of our reportable industry segments are discussed separately in the following sections. Revenues and expenses are attributed to the operating segments with the exception of corporate income, which consists of investment income earned directly by the parent holding company and interest expense related to long-term debt held by the parent. Our effective tax rate for each period is significantly lower than the expected 35% statutory rate because a considerable portion of our net investment income is tax-exempt. During the three and six month periods ended June 30, 2004, our income included tax-exempt income of $5.0 million and $9.3 million, respectively. During the three and six month periods ended June 30, 2003, our income included tax-exempt income of $3.7 million and $7.9 million, respectively. 24 PROFESSIONAL LIABILITY SEGMENT Selected financial data for our professional liability segment for the three and six months ended June 30, 2004 and 2003 are summarized in the table below.
Three Months Ended Six Months Ended June 30 June 30 --------------------- Increase ------------------- Increase 2004 2003 (Decrease) 2004 2003 (Decrease) ---- ---- ---------- ---- ---- ---------- $ In thousands Revenues: Gross premiums written $ 107,995 $107,567 $ 428 $277,733 $265,816 $ 11,917 ========= ======== ======== ======== ======== ======== Net premiums written $ 94,713 $ 91,967 $ 2,746 $246,996 $230,790 $ 16,206 ========= ======== ======== ======== ======== ======== Premiums earned $ 133,371 $121,856 $ 11,515 $271,794 $238,754 $ 33,040 Less: premiums ceded 12,767 16,689 (3,922) 27,633 35,350 (7,717) --------- -------- -------- -------- -------- -------- Net premiums earned 120,604 105,167 15,437 244,161 203,404 40,757 Net investment income 17,791 15,379 2,412 35,090 29,991 5,099 Net realized investment gains (44) 1,780 (1,824) 2,883 2,612 271 Other income 576 1,365 (789) 999 2,558 (1,559) --------- -------- -------- -------- -------- -------- Total revenues 138,927 123,691 15,236 283,133 238,565 44,568 --------- -------- -------- -------- -------- -------- Expenses: Loss and loss adjustment expenses 117,092 117,187 (95) 240,899 231,189 9,710 Less: reinsurance recoveries 9,279 13,239 (3,960) 17,879 29,187 (11,308) --------- -------- -------- -------- -------- -------- Net losses and loss adjustment expenses 107,813 103,948 3,865 223,020 202,002 21,018 Underwriting, acquisition and insurance expenses 19,246 16,803 2,443 37,389 32,298 5,091 --------- -------- -------- -------- -------- -------- Total expenses 127,059 120,751 6,308 260,409 234,300 26,109 --------- -------- -------- -------- -------- -------- Income before income taxes $ 11,868 $ 2,940 $ 8,928 $ 22,724 $ 4,265 $ 18,459 ========= ======== ======== ======== ======== ======== Net loss ratio * 89.4% 98.8% (9.4%) 91.3% 99.3% (8.0%) Underwriting expense ratio * 16.0% 16.0% --% 15.3% 15.9% (0.6%) --------- -------- -------- -------- -------- -------- Combined ratio 105.4% 114.8% (9.4%) 106.6% 115.2% (8.6%) Less: Investment income ratio * 14.8% 14.6% 0.2% 14.4% 14.7% (0.3%) --------- -------- -------- -------- -------- -------- Operating ratio 90.6% 100.2% (9.6%) 92.2% 100.5% (8.3%) ========= ======== ======== ======== ======== ========
* Ratios shown are expressed as a percentage of net premiums earned.
JUNE 30 December 31 2004 2003 ---- ---- $ In thousands Identifiable segment assets $2,541,824 $2,413,043 ========== ========== Net reserve for losses $1,410,544 $1,298,458 ========== ==========
25 Premiums Premiums written Written premium can vary from period to period for a number of reasons. Some of the more common differences result from changes to premium rates, the volume of new business written during the period, the loss of business to competitors or due to our own underwriting decisions, and the percentage of our policies that renew, which may also affect the level of tail premiums written. Strategic factors, such as our decision to convert our remaining occurrence policies to claims-made coverage, may also affect written premiums from period to period. The effect of any of these changes also varies by the proportion of policies written or renewed during each period in the various geographical regions and classes of business in which we operate. Premiums written for the professional liability segment increased by $428,000 for the three months and $11.9 million for the six months ended June 30, 2004 as compared to the same periods in 2003. As rate adequacy has improved, we have required lower rate increases in some states. Renewals during the second quarter have been at rates that are approximately 15% higher than expiring rates whereas renewals during first quarter of 2004 and all of 2003 were at least 20% higher than expiring rates. We have continued to convert our remaining occurrence policies to claims-made policies. First-year claims-made coverage has a significantly lower premium than occurrence coverage due to lower loss exposure. This process, which we began in 2003, is substantially complete at June 30, 2004. A majority of our occurrence policyholders accepted the conversion to claims-made coverage. The conversion reduced 2004 premiums written as compared to 2003 by approximately $2.2 million in the three month period and $9.4 million for the six month period. As compared to the same periods in 2003, we wrote $1.6 million less "tail" premiums in the second quarter of 2004 as compared to the second quarter of 2003. Tail premium provides coverage for incurred but not reported claims of specific prior periods and is written to physicians that are discontinuing their claims-made coverage with us. We prefer not to write tail coverage due to the occurrence-like loss liability that it creates, but the decision to purchase this coverage is the option of the departing policyholder. Premiums written for this coverage can vary significantly from period to period. Premiums earned Premiums earned for the professional liability segment increased $11.5 million for the three months and $33.0 million for the six months ended June 30, 2004 as compared to the same periods in 2003. Premiums are earned pro rata over the entire policy period (generally one year) after the policy is written and the increase in 2004 earned premiums reflects on a pro rata basis the changes in written premiums that occurred during both 2004 and 2003. Thus earned premiums have increased at varying levels for the reasons discussed in the section on premiums written. Premiums ceded Premiums ceded represent the premiums we must ultimately pay to our reinsurers for their assumption of a portion of our losses. Premiums ceded decreased by $3.9 million and $7.7 million for the three and six month periods ended June 30, 2004, respectively, as compared to the same periods in 2003 primarily because we have reduced the portion of our losses that we cede to our reinsurers. Beginning in October 2002 we increased our retention levels for virtually all medical liability losses from as low as $250,000 to $1.0 million. This has the effect of reducing ultimate premiums ceded. Premiums ceded for the three and six month periods ended June 30, 2004 fully reflect the effects of this change in retention levels, whereas the change had a less significant effect on premiums ceded for the three and six month periods ended June 30, 2003. 26 Losses and Loss Adjustment Expenses Calendar year losses may be divided into three components: (i) actuarial evaluation of incurred losses for the current accident year; (ii) actuarial re-evaluation of incurred losses for prior accident years; and (iii) actuarial re-evaluation of the reserve for the death, disability and retirement provision (DDR) in our claims-made policies. Accident year refers to the accounting period in which the insured event becomes a liability of the insurer. For occurrence policies the insured event becomes a liability when the event takes place; for claims-made policies the insured event becomes a liability when the event is first reported to the insurer. We believe that measuring losses on an accident year basis is the most indicative measure of the underlying profitability of the premiums earned in that period since it associates policy premiums earned with our estimate of the losses incurred related to those policy premiums. Calendar year results include the operating results for the current accident year and, as discussed in critical accounting policies, any changes in estimates related to prior accident years. The following table summarizes professional liability net losses and net loss ratios for the three and six month periods ended June 30, 2004 and 2003 by separating losses between the current accident year and all prior accident years. The net loss ratios shown are calculated by dividing the applicable net losses by calendar year net premiums earned.
Three Months Ended Six Months Ended June 30 June 30 ------------------------------ ------------------------- 2004 2003 2004 2003 ---- ---- ---- ---- $ In Thousands Net losses: Current accident year $ 107,813 $ 103,198 $ 223,020 $ 201,252 Change in prior accident years net losses - 750 - 750 ----------- ------------ ----------- ------------ Calendar year net losses $ 107,813 $ 103,948 $ 223,020 $ 202,002 =========== ============ =========== ============ Net loss ratio attributable to: Current accident year 89.4% 98.1% 91.3% 98.9% Change in prior accident years losses - 0.7% - 0.4% ----------- ------------ ----------- ------------ Calendar year net loss ratio 89.4% 98.8% 91.3% 99.3% =========== ============ =========== ============
Current accident year net losses increased by $4.6 million and $21.8 million for the three and six months ended June 30, 2004 as compared to same periods of 2003. There is little change in the number of insured risks during 2004 as compared to 2003; net losses increased during 2004 primarily because of higher loss costs. The current accident year net loss ratio for the three months ended June 30, 2004, as compared to the same period in 2003, has decreased from 98.1% to 89.4%. The current accident year net loss ratio for the six months ended June 30, 2004 decreased to 91.3% as compared to 98.9% for the same period in 2003. The 2004 loss ratios are lower than the 2003 ratios primarily because premium rates increased at a faster pace than did loss costs. 27 Net Investment Income and Net Realized Investment Gains (Losses) Our professional liability segment investment income is primarily derived from the interest income earned by our fixed maturity securities but also includes interest income from short-term and cash equivalent investments, dividend income from equity securities, increases in the cash surrender value of business owned executive life insurance contracts, and rental income earned by our commercial real estate holdings. Investment fees and expenses and real estate expenses are deducted from investment income. Investment income is a substantial revenue source for the professional liability segment because, on average, premiums are collected some years before the related losses are paid. Our net investment income increased by $2.4 million and $5.1 million, respectively, for the three and six month periods ended June 30, 2004 as compared to the same periods in 2003. The increase in investment income primarily resulted from higher average invested funds in 2004. Offsetting the positive effect of additional invested funds is a decline in our average yield on fixed maturity investments. Because prevailing market interest rates have remained low, new and matured funds have been invested at yields that are lower than the average yield of our fixed maturity portfolio. Additionally, during 2004 we have increased our average investment in tax-exempt securities and, on a before-tax basis, yields on tax-exempt securities are lower than yields on taxable securities. The weighted average tax equivalent book yield (tax adjusted gross earnings divided by the average quarterly ending book value) of our professional liability segment fixed maturity investments is 4.4% during both the three and six month periods ended June 30, 2004 as compared to 4.8% and 4.9%, respectively, for the same periods in 2003. The investment income ratio, defined as net investment income as a percentage of net premiums earned, for the three and six month periods ended June 30, 2004 is 14.8% and 14.4% respectively, as compared to ratios of 14.6% and 14.7%, respectively, for the three and six month periods ended June 30, 2003, respectively. These ratio changes result from both the premium changes and the changes in investment income, all of which are discussed above. Net realized investment gains decreased by $1.8 million and increased by $0.3 million, respectively, for the three and six month periods ended June 30, 2004 as compared to the same periods in 2003. The increase primarily resulted from gains realized on the sale of fixed maturity securities. We sell these securities from time to time in order to manage our liquidity needs and to achieve various investment management objectives, including maximizing total yields on certain securities. The components of net realized investment gains are shown in the following table.
Three Months Ended Six Months Ended June 30 June 30 ------------------ ------------------- 2004 2003 2004 2003 ---- ---- ---- ---- $ In thousands Net gains (losses) from sales $(32) $ 1,813 $ 2,886 $ 2,934 Other-than-temporary impairment losses - (33) - (322) Holding gains (losses) on trading portfolio (12) - (3) - ---- ------- ------- ------- Net realized investment gains (losses) $(44) $ 1,780 $ 2,883 $ 2,612 ==== ======= ======= =======
28 Underwriting, Acquisition and Insurance Expenses Underwriting, acquisition and insurance expenses increased by $2.4 million and $5.1 million, respectively, for the three and six month periods ended June 30, 2004 as compared to the same periods in 2003. These expenses are comprised of variable costs, such as commissions and premium taxes that are directly related to premiums earned, and fixed costs that have an indirect relationship to premium volume, such as salaries, benefits, facility costs and guaranty fund assessments. The 2004 increase in expenses reflects higher variable costs incurred as a result of premium growth as well as higher costs for salaries, benefits, and professional fees. The underwriting expense ratio is the total of underwriting, acquisition and insurance expenses divided by net premiums earned. This ratio is 16.0% and 15.3%, respectively, for the three and six month periods ended June 30, 2004 as compared to 16.0% and 15.9%, respectively, for the same periods in 2003. Guaranty fund assessments are amounts we are required to contribute to state insolvency or guaranty fund associations when so assessed by the state. Such assessments can and do vary significantly from period to period. Guaranty fund assessments were approximately $124,000 and $283,000, respectively, for the three and six month periods ended June 30, 2004 as compared to approximately $113,000 and $224,000 for the respective periods in 2003. 29 PERSONAL LINES SEGMENT Our personal lines segment is comprised of the operations of a single insurance company, MEEMIC Insurance Company. Selected financial data for our personal lines segment is summarized in the table below.
Three Months Ended Six Months Ended June 30 June 30 ------------------- Increase ------------------ Increase 2004 2003 (Decrease) 2004 2003 (Decrease) ---- ---- ---------- ---- ---- ---------- $ In thousands Revenues: Gross premiums written $55,761 $ 50,239 $ 5,522 $104,750 $94,650 $ 10,100 ======= ======== ======== ======== ======= ======== Net premiums written $49,540 $ 46,311 $ 3,229 $ 92,719 $86,424 $ 6,295 ======= ======== ======== ======== ======= ======== Premiums earned $51,499 $ 46,434 $ 5,065 $101,604 $90,689 $ 10,915 Less: Premiums ceded 6,206 3,917 2,289 12,026 8,213 3,813 ------- -------- -------- -------- ------- -------- Net premiums earned 45,293 42,517 2,776 89,578 82,476 7,102 Net investment income 2,791 2,458 333 5,297 5,032 265 Net realized investment gains (losses) 31 (74) 105 51 101 (50) Other income 656 526 130 1,244 992 252 ------- -------- -------- -------- ------- -------- Total revenues 48,771 45,427 3,344 96,170 88,601 7,569 ------- -------- -------- -------- ------- -------- Expenses: Loss and loss adjustment expenses 44,618 53,369 (8,751) 73,484 85,013 (11,529) Less: Reinsurance recoveries 15,652 26,017 (10,365) 17,804 30,667 (12,863) ------- -------- -------- -------- ------- -------- Net losses and loss adjustment expenses 28,966 27,352 1,614 55,680 54,346 1,334 Underwriting, acquisition and insurance expenses 10,121 9,431 690 19,950 18,358 1,592 ------- -------- -------- -------- ------- -------- Total expenses 39,087 36,783 2,304 75,630 72,704 2,926 ------- -------- -------- -------- ------- -------- Income before income taxes and minority interest $ 9,684 $ 8,644 $ 1,040 $ 20,540 $15,897 $ 4,643 ======= ======== ======== ======== ======= ======== Net Loss ratio * 64.0% 64.3% (0.3%) 62.2% 65.9% (3.7%) Underwriting expense ratio * 22.3% 22.2% 0.1% 22.3% 22.3% --% ------- -------- -------- -------- ------- -------- Combined ratio 86.3% 86.5% (0.2%) 84.5% 88.2% (3.7%) Less: Investment income ratio * 6.2% 5.8% 0.4% 5.9% 6.1% (0.2%) ------- -------- -------- -------- ------- -------- Operating ratio 80.1% 80.7% (0.6%) 78.6% 82.1% (3.5%) ======= ======== ======== ======== ======= ========
* Ratios shown are expressed as a percentage of net premiums earned.
JUNE 30 December 31 2004 2003 ---- ---- $ In thousands Identifiable segment assets $457,642 $431,264 ======== ======== Net reserves for losses $ 71,966 $ 71,315 ======== ========
30 Premiums Premiums written Gross premiums written for the three and six month periods ended June 30, 2004, increased by $5.5 million and $10.1 million, respectively, as compared to the same periods ended June 30, 2003. Premiums by line of business for each period are as follows.
Three Months Ended Six Months Ended June 30 June 30 -------------------------- -------------------------- 2004 2003 2004 2003 ---- ---- ---- ---- $ In millions Automobile $ 43.9 $ 40.2 $ 85.3 $ 78.4 Homeowners 11.5 9.7 19.0 15.8 Boat and umbrella 0.4 0.3 0.5 0.5 --------- --------- --------- --------- $ 55.8 $ 50.2 $ 104.8 $ 94.7 ========= ========= ========= =========
Automobile premiums increased in 2004 primarily because the number of vehicles insured increased by 5.0%. Also, the values of insured autos increased in addition to rate increases of 1.1% and 0.6% that became effective April 1, 2004 and October 1, 2003, respectively. Homeowners premiums increased during 2004 due to 11.3% growth in the number of homes insured, increases in the value of those homes, and rate increases of 3.7% and 7.6% that became effective April 1, 2004 and 2003, respectively. Premiums earned Premiums earned increased by $5.1 million and $10.9 million, respectively, for the three and six month periods ended June 30, 2004 as compared to the same periods in 2003. Premiums are earned pro rata over the entire policy period after the policy is written. The increases in 2004 earned premiums therefore reflect on a pro rata basis the changes in written premiums that occurred during both 2004 and 2003. Thus earned premiums have increased as discussed in the section on premiums written. Premiums ceded Premiums ceded represent the premiums we must ultimately pay to our reinsurers for their assumption of a portion of our losses. Premiums ceded increased for the three and six month periods ended June 30, 2004 as compared to the same periods in 2003. The increases are due primarily to the increased volume of our business and increased mandatory assessments charged by the Michigan Catastrophic Claims Association for which a corresponding amount is charged to policyholders in premiums. 31 Losses and Loss Adjustment Expenses The following table summarizes personal lines net losses and net loss ratios for the three and six month periods ended June 30, 2004 and 2003 by separating losses between the current accident year and all prior accident years. The net loss ratios shown are calculated by dividing the applicable net losses by calendar year net premiums earned.
Three Months Ended Six Months Ended June 30 June 30 ------------------------ ---------------------- 2004 2003 2004 2003 ---- ---- ---- ---- $ In thousands Net losses: Current accident year $ 31,966 $ 29,424 $ 61,174 $ 57,806 Change in prior accident years net losses (3,000) (2,072) (5,494) (3,460) --------- ----------- ----------- ------------ Calendar year net losses $ 28,966 $ 27,352 $ 55,680 $ 54,346 ========= =========== =========== ============ Net loss ratio attributable to: Current accident year 70.6% 69.2% 68.3% 70.1% Change in prior accident years losses (6.6%) (4.9%) (6.1%) (4.2%) --------- ----------- ----------- ------------ Calendar year net loss ratio 64.0% 64.3% 62.2% 65.9% ========= =========== =========== ============
Current accident year net losses for the three and six month periods ended June 30, 2004 increased by $2.5 million and $3.4 million, respectively, as compared to the same periods in 2003. The increases in total net losses are due to a greater number of insureds in 2004. The increase in net loss ratio for the three months ended June 30, 2004 compared to the same period in 2003 is due to increased water damage claims from severe thunderstorms in May 2004. The decrease in net loss ratio for the six months ended June 30, 2004 compared to the same period in 2003 is due to a reduction in the number of auto collision claims during the first six months of 2004 relative to the level of premiums earned. We reduced prior accident years' net losses during both 2004 and 2003 as a result of favorable developments in our estimates of prior years' auto liability reserves. Net Investment Income and Net Realized Investment Gains (Losses) Our net investment income is comprised of the interest and dividend income from our fixed maturity, short-term, cash equivalents and equity investments, net of investment expenses. Investment income as a percent of net premiums earned for the three and six month periods ended June 30, 2004 is 6.2% and 5.9%, respectively, as compared to ratios of 5.8% and 6.1%, respectively, for the three and six month periods ended June 30, 2003. The weighted average tax equivalent book yield (tax adjusted gross earnings divided by the average quarterly ending book value) of the personal lines segment fixed maturity investments is 5.4% and 5.3% for the three and six month periods ended June 30, 2004, respectively, as compared to 5.7% and 5.9% for the same respective periods in 2003. The average yield is reduced as compared to 2003 because market rates available for the investment of new and matured funds were lower in 2004. Net realized investment gains and losses for the three and six-month periods ended June 30, 2004 and 2003 did not include any other-than-temporary impairments. 32 Underwriting, Acquisition and Insurance Expenses Underwriting, acquisition and insurance expenses consist of normal, recurring expenses such as commissions, salaries and other expenses. These expenses increased by approximately $0.7 million and $1.6 million for the three and six month periods ended June 30, 2004, respectively, as compared to the same periods in 2003, primarily due to higher underwriting and acquisition costs from premium growth. The underwriting expense ratio (underwriting, acquisition and insurance expenses divided by net premiums earned) is 22.3% for both the three and six month periods ended June 30, 2004 as compared to 22.2% and 22.3% for the three and six month periods ended June 30, 2003, respectively. Guaranty fund assessments total $125,000 and $250,000 for each of the three and six month periods ended June 30, 2004 and 2003, respectively. 33 REVENUE AND EXPENSE NOT ATTRIBUTED TO SEGMENTS Revenues and expenses not attributed to our operating segments are summarized below.
Three Months Ended Six Months Ended June 30 June 30 ------------------ Increase --------------------- Increase 2004 2003 (Decrease) 2004 2003 (Decrease) ---- ---- ---------- ---- ---- ---------- $ In thousands Investment revenues directly earned by the parent holding company: Net investment income $ 101 $ 7 $ 94 $ 147 $ 69 $ 78 Net realized investment gains 639 - 639 1,349 - 1,349 ------ ---- ---- ------ ------ ------ Total unallocated revenues 740 7 733 1,496 69 1,427 ------ ---- ---- ------ ------ ------ Interest expense on debt 1,492 491 1001 2,635 1,069 1,566 ------ ---- ---- ------ ------ ------ Unallocated expense in excess of unallocated revenues $ 752 $484 $268 $1,139 $1,000 $ 139 ====== ==== ==== ====== ====== ======
The increase in net investment income is primarily attributable to the investment of the net proceeds from issuance of the trust preferred securities of $43.6 million. Interest expense increased during the three and six month periods ended June 30, 2004 as compared to the same periods in 2003 for several reasons. The Debentures issued in July 2003 increased the amount of outstanding long-term debt and carry a higher interest rate than did the bank term loan that was repaid. The Subordinated Debentures issued in April and May, 2004 increased the total amount of debt outstanding. 34 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We believe that we are principally exposed to three types of market risk related to our investment operations. These risks are interest rate risk, credit risk and equity price risk. The term market risk refers to the risk of loss arising from adverse changes in market rates and prices, such as interest rates, equity prices and foreign currency exchange rates. As of June 30, 2004, our fair value investment in fixed maturity securities was $2.019 billion. These securities are subject primarily to interest rate risk and credit risk. We have not and currently do not intend to enter into derivative transactions. INTEREST RATE RISK Our fixed maturities portfolio is exposed to interest rate risk. Fluctuations in interest rates have a direct impact on the market valuation of these securities. As interest rates rise, market values of fixed income portfolios fall and vice versa. We believe we are in a position to keep our fixed income investments until maturity as we do not invest in fixed maturity securities for trading purposes.
JUNE 30, 2004 December 31, 2003 --------------------------------------- ---------------------- PORTFOLIO CHANGE IN MODIFIED Portfolio Modified VALUE VALUE DURATION Value Duration Interest Rates $ MILLIONS $ MILLIONS YEARS $ Millions Years -------------- ---------- ---------- ----- ---------- ----- 200 basis point rise $1,868 $(151) 3.93 $1,664 3.73 100 basis point rise $1,943 $ (76) 4.02 $1,727 3.63 Current rate * $2,019 $ - 3.77 $1,791 3.54 100 basis point decline $2,095 $ 76 3.62 $1,854 3.45 200 basis point decline $2,171 $ 152 3.60 $1,919 3.52
*Current rates are as of June 30, 2004 and December 31, 2003 At June 30, 2004, the fair value of our investment in preferred stocks was $21.0 million, including net unrealized gains of $0.6 million. Preferred stocks are primarily subject to interest rate risk because they bear a fixed rate of return. The investments in the above table do not include preferred stocks. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the maintenance of the existing level and composition of fixed income security assets, and should not be relied on as indicative of future results. Certain shortcomings are inherent in the method of analysis presented in the computation of the fair value of fixed rate instruments. Actual values may differ from those projections presented should market conditions vary from assumptions used in the calculation of the fair value of individual securities, including non-parallel shifts in the term structure of interest rates and changing individual issuer credit spreads. Our cash and short-term investment portfolio at June 30, 2004 was on a cost basis which approximates its fair value. This portfolio lacks significant interest rate sensitivity due to its short duration. 35 CREDIT RISK We have exposure to credit risk primarily as a holder of fixed income securities. We control this exposure by emphasizing investment grade credit quality in the fixed income securities we purchase. As of June 30, 2004, over 99% of our fixed income portfolio consisted of securities rated investment grade. We believe that this concentration in investment grade securities reduces our exposure to credit risk on these fixed income investments to an acceptable level. However, in the current environment even investment grade securities can rapidly deteriorate and result in significant losses. EQUITY PRICE RISK At June 30, 2004 the fair value of our investment in common stocks was $23.5 million, which included net unrealized gains of $3.2 million and net holding gains of approximately $1.7 million. These securities are subject to equity price risk, which is defined as the potential for loss in market value due to a decline in equity prices. A hypothetical 10% increase in the market prices as of June 30, 2004 would increase the fair value of these securities to $25.9 million; a hypothetical 10% decrease in the price of each of these marketable securities would reduce the fair value to $21.2 million. The selected hypothetical change does not reflect what could be considered the best or worst scenarios. ITEM 4. CONTROLS AND PROCEDURES The Chief Executive Officer and Chief Financial Officer of the Company evaluated the effectiveness of our disclosure controls and procedures (as defined in SEC Rule 13a-15(e)) as of June 30, 2004. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective. During the quarter ended June 30, 2004, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f)) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 36 FORWARD-LOOKING STATEMENTS The U.S. securities laws, including the Private Securities Litigation Reform Act of 1995, provide a "safe harbor" for certain forward-looking statements. This report and the documents incorporated by reference herein contain statements concerning our future results and performance and other matters that are "forward-looking" statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. The words "anticipates," "believes," "estimates," "expects," "plans," "intends" and similar expressions are intended, but are not the exclusive means, to identify these forward-looking statements. These forward-looking statements include among other things statements concerning: liquidity and capital requirements, return on equity, financial ratios, net income, premiums, losses and loss reserves, premium rates and retention of current business, competition and market conditions, the expansion of product lines, the development or acquisition of business in new geographical areas, the availability of acceptable reinsurance, actions by regulators and rating agencies, payment of dividends, and other matters. These forward-looking statements are based upon our estimates and anticipation of future events that are subject to certain risks and uncertainties that could cause actual results to vary materially from historical or expected results described in the forward-looking statements. Due to such risks and uncertainties, you are urged not to place undue reliance on forward-looking statements. Risks that could adversely affect our operations or cause actual results to differ materially from anticipated results include, but are not limited to, the following: - underwriting losses on the risks we insure are higher or lower than expected; - unexpected changes in loss trends and reserving assumptions which might require the reevaluation of the liability for loss and loss adjustment expenses, thus resulting in an increase or decrease in the liability and a corresponding adjustment to earnings; - our ability to retain current business, acquire new business, expand product lines and a variety of other factors affecting daily operations such as, but not limited to, economic, legal, competitive and market conditions which may be beyond our control and are thus difficult or impossible to predict; - changes in the interest rate environment and/or the securities markets that adversely impact the fair value of our investments or our income; - inability on our part to achieve continued growth through expansion into other states or through acquisitions or business combinations; - general economic conditions that are worse than anticipated; - inability on our part to obtain regulatory approval of, or to implement, premium rate increases; - the effects of weather-related events; - changes in the legal system, including retroactively applied decisions that affect the frequency and severity of claims; - a verdict against one of our insureds that is in excess of policy limits could expose us to bad faith litigation by the insured; - significantly increased competition among insurance providers and related pricing weaknesses in some markets; - the loss of an agent or agents who produce a significant portion of our business; - changes in the availability, cost, quality or collectibility of reinsurance; - changes to our ratings by rating agencies; - regulatory and legislative actions or decisions that adversely affect us; and - our ability to utilize loss carryforwards and other deferred tax assets. All forward-looking statements included in this document are based upon information available to us on the date hereof, and we undertake no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We do not assume responsibility for the accuracy and completeness of the forward-looking statements. We caution you that these risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict such new risk factors, nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied by any forward-looking statements. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this prospectus might not occur. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in Section 27A of the Securities Act. 37 PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Note 9 to the condensed consolidated financial statements. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. 4.1 ProAssurance Corporation Floating Rate Junior Subordinated Debenture due 2034 issued as on May 26, 2004 in original principal amount of $22,682,000. 4.2 ProAssurance Corporation Floating Rate Junior Subordinated Debenture due 2034 issued as on May 12, 2004 in original principal amount of $10,310,000. 4.3 Amended and Restated Declaration of Trust of ProAssurance Capital Trust II dated as of May 12, 2004. 4.4 Preferred Securities Guarantee Agreement ProAssurance Capital Trust II dated as of May 12, 2004. 4.5 Indenture between ProAssurance Corporation and Wilmington Trust Company as Trustee dated as of May 12, 2004. 31.1 Certification of Principal Executive Officer of ProAssurance as required under SEC rule 13a-14(a). 31.2 Certification of Principal Financial Officer of ProAssurance as required under SEC rule 13a-14(a). 32.1 Certification of Principal Executive Officer of ProAssurance as required under SEC Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as amended (18 U.S.C. 1350). 32.2 Certification of Principal Financial Officer of ProAssurance as required under SEC Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as amended (18 U.S.C. 1350). (b) Reports on Form 8-K. ProAssurance filed a Current Report on Form 8-K on April 30, 2004 that furnished information publicly released announcing its placement of $13 million in Trust Preferred Securities. ProAssurance filed a Current Report on Form 8-K on May 10, 2004 that furnished the information publicly released regarding its announcement of the company's results for the first quarter ended March 31, 2004. ProAssurance filed a Current Report on Form 8-K on May 13, 2004 that furnished information publicly released regarding its announcement of a placement of $10 million in Trust Preferred Securities. ProAssurance filed a Current Report on Form 8-K on May 26, 2004 that furnished the information publicly released regarding its announcement of a placement of $22 million in Trust Preferred Securities. ProAssurance filed a Current Report on Form 8-K on June 21, 2004 that furnished information publicly released regarding its announcement on A.M. Best's affirmation of the Company's Financial Strength Rating and its core insurance subsidiaries. (c) The exhibits required to be filed by Item 15(c) are listed herein in the Exhibit Index. 38 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PROASSURANCE CORPORATION August 4, 2004 /s/ Howard H. Friedman --------------------------- Howard H. Friedman, Chief Financial Officer (Duly authorized officer and principal financial officer) 39