-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, L/zr1pF1ccCqtej739epm/8iQQfYHK8KHwy+z3s2dQMIGdbNTeq0lBBpwrlhuE2X WsIWjdscsUH+mIPN/5pR2w== 0000950144-04-010725.txt : 20041109 0000950144-04-010725.hdr.sgml : 20041109 20041109140300 ACCESSION NUMBER: 0000950144-04-010725 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041109 DATE AS OF CHANGE: 20041109 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PROASSURANCE CORP CENTRAL INDEX KEY: 0001127703 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 631261433 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-16533 FILM NUMBER: 041128776 BUSINESS ADDRESS: STREET 1: 100 BROOKWOOD PLACE CITY: BIRMINGHAM STATE: AL ZIP: 35209 BUSINESS PHONE: 2058774400 10-Q 1 g91593e10vq.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 SEPTEMBER 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 September 30, 2004 there were 29,187,829 shares of the registrant's common stock outstanding. Page 1 of 37 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......................................33 Item 4. Controls and Procedures........................................................................34 Forward-Looking Statements..............................................................................35 Part II - Other Information Item 1. Legal Proceedings..............................................................................36 Item 6. Exhibits and Reports on 8-K....................................................................36 Signature...............................................................................................37
PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE DATA)
SEPTEMBER 30 December 31 ------------------------------------- 2004 2003 ------------------------------------- ASSETS Investments: Fixed maturities available for sale, at fair value $2,121,710 $ 1,790,778 Equity securities available for sale, at fair value 34,254 42,136 Equity securities, trading portfolio, at fair value 1,276 5,863 Real estate, net 18,842 17,262 Short-term investments 104,293 109,680 Business owned life insurance 53,557 51,706 Other 41,951 38,247 ------------------------------------- Total investments 2,375,883 2,055,672 Cash and cash equivalents 30,551 47,132 Premiums receivable 138,677 132,255 Receivable from reinsurers on unpaid losses and loss adjustment expenses 462,005 444,811 Prepaid reinsurance premiums 18,684 17,651 Deferred taxes 77,091 73,118 Other assets 114,280 108,713 ------------------------------------- $3,217,171 $2,879,352 ===================================== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Policy liabilities and accruals: Reserve for losses and loss adjustment expenses $2,007,116 $1,814,584 Unearned premiums 320,936 290,134 Reinsurance premiums payable 78,124 68,510 ------------------------------------- Total policy liabilities 2,406,176 2,173,228 Other liabilities 65,864 55,030 Long-term debt 151,406 104,789 ------------------------------------- Total liabilities 2,623,446 2,333,047 Commitments and contingencies - - Stockholders' Equity: Common stock, par value $0.01 per share 100,000,000 shares authorized; 29,309,594 and 29,226,774 shares issued, respectively 293 292 Additional paid-in capital 313,793 312,030 Accumulated other comprehensive income, net of deferred tax expense of $15,497 and $18,537, respectively 28,776 34,422 Retained earnings 250,919 199,617 ------------------------------------- 593,781 546,361 Less treasury stock, at cost, 121,765 shares (56) (56) ------------------------------------- Total stockholders' equity 593,725 546,305 ------------------------------------- $3,217,171 $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 51,302 - 51,302 - Change in fair value of securities available for sale, net of reclassification adjustments and deferred taxes (5,646) (5,646) - - Common stock issued for compensation 1,599 - - 1,599 Common stock options exercised 165 - - 165 --------------------------------------------------------------------- Balance at September 30, 2004 $ 593,725 $ 28,776 $ 250,919 $ 314,030 ===================================================================== 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 24,876 - 24,876 - Change in fair value of securities available for sale, net of reclassification adjustments and deferred taxes 5,296 5,296 - - Acquisition of minority interest 886 886 - - Common stock issued for compensation 1,073 - - 1,073 Common stock options exercised 342 - - 342 --------------------------------------------------------------------- Balance at September 30, 2003 $ 537,667 $ 41,727 $ 185,790 $ 310,150 =====================================================================
See accompanying notes. 4 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ------------------------------ ------------------------------ 2004 2003 2004 2003 --------------- -------------- -------------- --------------- Revenues: Gross premiums written $ 217,812 $ 196,750 $ 600,295 $ 557,216 ============================================================= Net premiums written $ 198,370 $180,620 $ 538,085 $ 497,834 ============================================================= Premiums earned $ 196,185 $ 184,756 $ 569,583 $ 514,199 Premiums ceded 20,839 19,326 60,497 62,889 ------------------------------------------------------------- Net premiums earned 175,346 165,430 509,086 451,310 Net investment income 22,659 18,301 63,192 53,393 Net realized investment gains (losses) 3,063 1,436 7,346 4,149 Other income 827 1,022 3,069 4,572 ------------------------------------------------------------- Total revenues 201,895 186,189 582,693 513,424 Expenses: Losses and loss adjustment expenses 163,583 171,901 477,966 488,103 Reinsurance recoveries 19,302 26,118 54,986 85,972 ------------------------------------------------------------- Net losses and loss adjustment expenses 144,281 145,783 422,980 402,131 Underwriting, acquisition and insurance expenses 30,355 26,438 87,695 77,094 Loss on early extinguishment of debt - 305 - 305 Interest expense 1,902 1,188 4,537 2,257 ------------------------------------------------------------- Total expenses 176,538 173,714 515,212 481,787 ------------------------------------------------------------- Income before income taxes and minority interest 25,357 12,475 67,481 31,637 Provision for income taxes: Current expense 6,760 4,624 14,414 10,763 Deferred expense (benefit) (921) (1,884) 1,765 (4,183) ------------------------------------------------------------- 5,839 2,740 16,179 6,580 ------------------------------------------------------------- Income before minority interest 19,518 9,735 51,302 25,057 Minority interest - - - 181 ------------------------------------------------------------- Net income $ 19,518 $ 9,735 $ 51,302 $ 24,876 ============================================================= Earnings per share: Basic $ 0.67 $ 0.34 $ 1.76 $ 0.86 ============================================================= Diluted $ 0.66 $ 0.33 $ 1.75 $ 0.85 ============================================================= Weighted average number of common shares outstanding: Basic 29,182 28,967 29,153 28,935 ============================================================= Diluted 29,400 29,165 29,395 29,108 =============================================================
See accompanying notes. 5 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED) (IN THOUSANDS)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ------------------------------------------------------ 2004 2003 2004 2003 ------------------------------------------------------ COMPREHENSIVE INCOME (LOSS): Net income $ 19,518 $ 9,735 $ 51,302 $ 24,876 Change in fair value of securities available for sale, net of deferred taxes and minority interest 22,696 (9,394) (2,546) 7,849 Reclassification adjustment for realized investment (gains) losses included in income, net of taxes (1,195) (979) (3,100) (2,553) ------------------------------------------------------ Comprehensive income (loss) $ 41,019 $ (638) $45,656 $ 30,172 ======================================================
See accompanying notes. 6 PROASSURANCE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30 ------------------------------- 2004 2003 ------------------------------- OPERATING ACTIVITIES Net cash provided (used) by operating activities $ 284,784 $ 217,336 INVESTING ACTIVITIES Purchases of available-for-sale securities: Fixed maturities (958,694) (916,128) Equity (602) (864) Proceeds from sale or maturity of available-for-sale securities: Fixed maturities 610,060 456,971 Equities 8,869 20,160 Purchase of other investments (3,150) (6,750) Net decrease in short-term investments 5,387 192,228 Purchase of business owned life insurance - (50,000) Other (8,162) (1,552) ------------------------------- Net cash provided (used) by investing activities (346,292) (305,935) ------------------------------- FINANCING ACTIVITIES Proceeds from issuance of long-term debt 46,395 104,641 Debt issuance costs (1,491) - Purchase of minority interest - (33,304) Repayment of debt - (72,500) Other 23 (398) ------------------------------- Net cash provided (used) by financing activities 44,927 (1,561) ------------------------------- Increase (decrease) in cash and cash equivalents (16,581) (90,160) Cash and cash equivalents at beginning of period 47,132 143,306 ------------------------------- Cash and cash equivalents at end of period $ 30,551 $ 53,146 ===============================
See accompanying notes. 7 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 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 three and nine month periods ended September 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 NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ---------------------------- ----------------------------- 2004 2003 2004 2003 ------------- -------------- -------------- -------------- Net income, as reported $ 19,518 $ 9,735 $ 51,302 $ 24,876 Add: Stock-based employee compensation expense recognized under APB 25 related to the exercise of options, net of related tax effects 12 18 160 59 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (338) (218) (962) (628) ---------------------------------------------------------- Pro forma net income $ 19,192 $ 9,535 $ 50,500 $ 24,307 ========================================================== Earnings per share: Basic--as reported $ 0.67 $ 0.34 $ 1.76 $ 0.86 ========================================================== Basic--pro forma $ 0.66 $ 0.33 $ 1.73 $ 0.84 ========================================================== Diluted--as reported $ 0.66 $ 0.33 $ 1.75 $ 0.85 ========================================================== Diluted--pro forma $ 0.65 $ 0.33 $ 1.72 $ 0.84 ==========================================================
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) SEPTEMBER 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, interest expense related to long-term debt and income taxes, 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) SEPTEMBER 30, 2004 2. SEGMENT INFORMATION (CONTINUED) The table below provides a reconciliation of segment information to total consolidated information (in thousands).
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ---------------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------------- Revenues: Professional liability segment $ 150,641 $ 139,163 $ 433,774 $ 377,728 Personal lines segment 49,396 46,920 145,565 135,521 Corporate (not attributed to segments) 1,858 106 3,354 175 ---------------------------------------------------------- Total revenues $ 201,895 $ 186,189 $ 582,693 $ 513,424 ========================================================== Income (loss) before taxes and minority interest: Professional liability segment $ 14,905 $ 6,663 $ 37,629 $ 10,928 Personal lines segment 10,496 7,199 31,035 23,096 Corporate (not attributed to segments) (44) (1,387) (1,183) (2,387) ---------------------------------------------------------- Income (loss) before taxes and minority interest 25,357 12,475 67,481 31,637 ==========================================================
SEPTEMBER 30 December 31 2004 2003 -------------------------------- Identifiable Assets: Professional liability segment $2,664,162 $2,413,043 Personal lines segment 480,411 431,264 Corporate (not attributed to segments) 72,598 35,045 -------------------------------- Total assets $3,217,171 $2,879,352 ================================ 10 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 2004 3. INVESTMENTS The amortized cost of available-for-sale fixed maturities and equity securities is $2.156 billion and $1.780 billion at September 30, 2004 and December 31, 2003, respectively. Proceeds from sales of fixed maturities and equity securities during the nine month periods ended September 30, 2004 and 2003 are $425.3 million and $274.3 million, respectively. Net realized investment gains (losses) are comprised of the following (in thousands): NINE MONTHS ENDED SEPTEMBER 30 ------------------------------- 2004 2003 ------------------------------- Gross realized gains $ 6,371 $ 6,475 Gross realized (losses) (1,595) (2,007) Other than temporary impairment (losses) - (322) Trading portfolio gains (losses) 2,570 3 ------------------------------- Net realized investment gains (losses) $ 7,346 $ 4,149 =============================== 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 $46.6 million and $39.8 million for the nine months ended September 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) SEPTEMBER 30, 2004 7. LONG-TERM DEBT Outstanding long-term debt, as of September 30, 2004 and December 31, 2003, consisted of the following (in thousands):
SEPTEMBER 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 $2,589 and $2,811 at September 30, 2004 and December 31, 2003, respectively. $ 105,011 $ 104,789 Trust Preferred Subordinated Debentures, unsecured, and bearing floating interest rate, adjustable quarterly, at three-month LIBOR plus 3.85%. Due September 30, 2004 Rate --- ----------------------- April 29, 2034 5.56% 13,403 - May 12, 2034 5.56% 10,310 - May 12, 2034 5.56% 22,682 - ------------------------------- $ 151,406 $ 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) SEPTEMBER 30, 2004 7. LONG-TERM DEBT (CONTINUED) Note 11 of ProAssurance's December 31, 2003 Notes to the Consolidated Financial Statements includes additional information regarding the terms of the Debentures. Trust Preferred 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 Condensed 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) SEPTEMBER 30, 2004 8. STOCKHOLDERS' EQUITY At September 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 September 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 resolution of these actions will not have a material adverse effect on ProAssurance's financial position. However, to the extent that the cost of resolving these actions exceeds the corresponding reserves, the legal actions could have a material effect on ProAssurance's results of operations for the period in which any such action is resolved. 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) SEPTEMBER 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 NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ------------------------- --------------------------- 2004 2003 2004 2003 --------------------------------------------------------- Numerator - Basic and Diluted: Net income $19,518 $ 9,735 $51,302 $24,876 ========================================================= Denominator/Basic: Weighted average number of common shares outstanding 29,182 28,967 29,153 28,935 ========================================================= Denominator/Diluted: Weighted average number of common shares outstanding 29,182 28,967 29,153 28,935 Assumed conversion of dilutive stock options and awards 218 198 242 173 --------------------------------------------------------- Diluted weighted average equivalent shares 29,400 29,165 29,395 29,108 ========================================================= Earnings per share: Basic $ 0.67 $ 0.34 $ 1.76 $ 0.86 ========================================================= Diluted $ 0.66 $ 0.33 $ 1.75 $ 0.85 =========================================================
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 nine month period ended September 30, 2004 and 2003, an average of 80,000 and 111,000 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 period. 12. VARIABLE INTEREST ENTITIES ProAssurance has adopted the provisions of Financial Accounting Standards Board (FASB) 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 $39.4 million at September 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 32%. 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. 15 PROASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 2004 12. VARIABLE INTEREST ENTITIES (CONTINUED) 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 September 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. 13. RECENT ACCOUNTING PRONOUNCEMENTS AND GUIDANCE On October 13, 2004, the FASB concluded that Statement 123R, "Share Based Payments" which would require companies to measure compensation cost for all share-based payments, including employee stock options, would be effective for public companies for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of Statement 123 and Statement 123R to the beginning of the fiscal year that includes the effective date would be permitted, but not required. Early adoption of Statement 123R is encouraged. The FASB is expected to issue Statement 123R during the 2004 fourth quarter. Management has not estimated the effect that Statement 123R will have on ProAssurance's results of operations. In September, 2004 the Emerging Issues Task Force of the FASB reached a consensus regarding Issue 04-08- "Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted EPS". Under current interpretations of SAFS 128, Earnings per Share, issuers of contingently convertible debt instruments (Co-Cos) exclude the potential common shares underlying the Co-Co (the Co-Co shares) from the calculation of diluted earnings per share until the market price or other conversion contingency is met. Currently ProAssurance's diluted earnings per share computations do not include the Co-Co shares because the market price contingency has not been met. Under the new consensus, Co-Co shares are to be included in diluted earnings per share computations (if dilutive) regardless of whether the market price contingency has been met. The consensus is expected to become effective for financial statements ending after December 15, 2004 and is to be retroactively applied to all periods presented. The expected effect of the new guidance is shown below.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Diluted EPS, no inclusion of Co-Co shares $ 0.66 $ 0.33 $ 1.75 $ 0.85 ==================================================== Diluted EPS, Co-Co shares included $ 0.65 $ 0.33 $ 1.71 $ 0.85 ====================================================
Co-Co shares are not included in the revised diluted EPS calculations for the nine month period ended September 30, 2003 because the effect would be anti-dilutive. 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 adjustment 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 adjustment is made. At September 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. Certain of our equity security purchases are designated 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 $285 million for the nine months ended September 30, 2004 as compared to $217 million for the nine months ended September 30, 2003. As in the prior year, the primary sources of our operating cash flows are net investment income and 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 20% to date in 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 $30.6 million at September 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. Our total investments increased from $2.056 billion at December 31, 2003 to $2.376 billion at September 30, 2004, of which fixed maturity securities comprise more than 87% of total investments at each of those dates. At September 30, 2004 fixed maturity securities had a fair value of $2.122 billion as compared to $1.791 billion at December 31, 2003. The increase since December 31, 2003 is primarily due to the investment of cash generated from operations, the transfer of funds from short-term investments and cash and cash equivalents and the investment of $44.9 million net proceeds from the sale of trust preferred securities in 2004. 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 September 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 September 30, 2004 is 3.97 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 unrealized gains related to our available-for-sale securities decreased by $8.7 million at September 30, 2004 as compared to December 31, 2003 primarily because average bond yields increased and prices declined during 2004. Net unrealized gains related to our available-for-sale securities increased by $33.1 million during the third quarter primarily because average bond yields decreased. 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 decisions in part 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. 19 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 and 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 July 2003 we received $104.6 million from the issuance of twenty-year 3.9% Convertible Debentures. Due June 2023 (the Convertible Debentures), 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 of $44.9 million, after commissions paid to placement agents. 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 September 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 nine month periods ended September 30, 2004 and 2003 are summarized below.
Three Months Ended Nine Months Ended September 30 September 30 Increase Increase ----------------------- ------------------------ 2004 2003 (Decrease) 2004 2003 (Decrease) ------------------------------------------------------------------------------ $ In thousands Income before income taxes and minority interest: Professional Liability Segment $14,905 $ 6,663 $ 8,242 $37,629 $10,928 $26,701 Personal Lines Segment 10,496 7,199 3,297 31,035 23,096 7,939 Corporate (not attributed to segments) (44) (1,387) 1,343 (1,183) (2,387) 1,204 ------------------------------------------------------------------------------ Consolidated $25,357 $12,475 $12,882 $67,481 $31,637 $35,844 ==============================================================================
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. Investment income has increased only slightly because increases in the size of 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 nine months ended September 30, 2004 is 83.1%, reflecting a net loss ratio of 91.0% for the professional liability segment and 61.3% 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 NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 For the three month period ended September 30, 2004, our consolidated net income is $19.5 million, or $0.66 per diluted share as compared to $9.7 million or $0.33 per diluted share for the same period in 2003. For the nine month period ended September 30, 2004, our consolidated net income is $51.3 million, or $1.75 per diluted share, as compared to $24.9 million or $0.85 per diluted share for the same period in 2003. Results for each period are summarized in the table below.
Three Months Ended Nine Months Ended September 30 Increase September 30 Increase ------------------------- -------------------------- 2004 2003 (Decrease) 2004 2003 (Decrease) --------------------------------------------------------------------------------- $ In thousands Revenues: Gross premiums written $ 217,812 $ 196,750 $ 21,062 $ 600,295 $ 557,216 $ 43,079 ================================================================================= Net premiums written $ 198,370 $ 180,620 $ 17,750 $ 538,085 $ 497,834 $ 40,251 ================================================================================= Net premiums earned 175,346 165,430 9,916 509,086 451,310 57,776 Net investment income 22,659 18,301 4,358 63,192 53,393 9,799 Net realized investment gains (losses) 3,063 1,436 1,627 7,346 4,149 3,197 Other income 827 1,022 (195) 3,069 4,572 (1,503) --------------------------------------------------------------------------------- Total revenues 201,895 186,189 15,706 582,693 513,424 69,269 --------------------------------------------------------------------------------- Expenses: Net losses and loss adjustment expenses 144,281 145,783 (1,502) 422,980 402,131 20,849 Underwriting, acquisition and insurance expenses 30,355 26,438 3,917 87,695 77,094 10,601 Loss on early extinguishment of debt - 305 (305) - 305 (305) Interest expense 1,902 1,188 714 4,537 2,257 2,280 --------------------------------------------------------------------------------- Total expenses 176,538 173,714 2,824 515,212 481,787 33,425 --------------------------------------------------------------------------------- Income before income taxes and minority interest 25,357 12,475 12,882 67,481 31,637 35,844 Income taxes 5,839 2,740 3,099 16,179 6,580 9,599 --------------------------------------------------------------------------------- Income before minority interest 19,518 9,735 9,783 51,302 25,057 26,245 Minority interest - - - - 181 (181) --------------------------------------------------------------------------------- Net income $ 19,518 $ 9,735 $ 9,783 $ 51,302 $ 24,876 $ 26,426 ================================================================================= Net loss ratio * 82.3% 88.1% (5.8%) 83.1% 89.1% (6.0%) Underwriting expense ratio * 17.3% 16.0% 1.3% 17.2% 17.1% 0.1% --------------------------------------------------------------------------------- Combined ratio 99.6% 104.1% (4.5%) 100.3% 106.2% (5.9%) Less: Investment income ratio * 12.9% 11.1% 1.8% 12.4% 11.8% 0.6% --------------------------------------------------------------------------------- Operating ratio 86.7% 93.0% (6.3%) 87.9% 94.4% (6.5%) =================================================================================
* Ratios shown are expressed as a ratio of net premiums earned. SEPTEMBER 30 December 31 2004 2003 ------------------------------- $ In thousands Total assets $ 3,217,171 $ 2,879,352 =============================== Net reserve for losses $ 1,545,111 $ 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 nine month periods ended September 30, 2004, our income included tax-exempt income of $5.3 million and $14.6 million, respectively. During the three and nine month periods ended September 30, 2003, our income included tax-exempt income of $4.1 million and $12.0 million, respectively. 24 PROFESSIONAL LIABILITY SEGMENT Selected financial data for our professional liability segment for the three and nine months ended September 30, 2004 and 2003 are summarized in the table below.
Three Months Ended Nine Months Ended September 30 Increase September 30 Increase -------------------------- -------------------------- 2004 2003 (Decrease) 2004 2003 (Decrease) ----------------------------------------------------------------------------------- $ In thousands Revenues: Gross premiums written $ 160,461 $ 145,526 $ 14,935 $ 438,194 $ 411,342 $ 26,852 =================================================================================== Net premiums written $ 148,452 $ 134,126 $ 14,326 $ 395,449 $ 364,916 $ 30,533 =================================================================================== Premiums earned $ 142,588 $ 136,277 $ 6,311 $ 414,382 $ 375,031 $ 39,351 Less: Premiums ceded 13,413 14,601 (1,188) 41,045 49,951 (8,906) ----------------------------------------------------------------------------------- Net premiums earned 129,175 121,676 7,499 373,337 325,080 48,257 Net investment income 19,480 15,583 3,897 54,569 45,574 8,995 Net realized investment gains 1,725 1,431 294 4,608 4,043 565 Other income 261 473 (212) 1,260 3,031 (1,771) ----------------------------------------------------------------------------------- Total revenues 150,641 139,163 11,478 433,774 377,728 56,046 ----------------------------------------------------------------------------------- Expenses: Losses and loss adjustment expenses 125,916 126,818 (902) 366,815 358,007 8,808 Less: Reinsurance recoveries 9,234 10,678 (1,444) 27,114 39,865 (12,751) ----------------------------------------------------------------------------------- Net losses and loss adjustment expenses 116,682 116,140 542 339,701 318,142 21,559 Underwriting, acquisition and insurance expenses 19,054 16,360 2,694 56,444 48,658 7,786 ----------------------------------------------------------------------------------- Total expenses 135,736 132,500 3,236 396,145 366,800 29,345 ----------------------------------------------------------------------------------- Income before income taxes and minority interest $ 14,905 $ 6,663 $ 8,242 $ 37,629 $ 10,928 $ 26,701 =================================================================================== Net loss ratio * 90.3% 95.5% (5.2%) 91.0% 97.9% (6.9%) Underwriting expense ratio * 14.8% 13.4% 1.4% 15.1% 15.0% 0.1% ----------------------------------------------------------------------------------- Combined ratio 105.1% 108.9% (3.8%) 106.1% 112.9% (6.8%) Less: Investment income ratio * 15.1% 12.8% 2.3% 14.6% 14.0% 0.6% ----------------------------------------------------------------------------------- Operating ratio 90.0% 96.1% (6.1%) 91.5% 98.9% (7.4%) === ===============================================================================
* Ratios shown are expressed as a percentage of net premiums earned. SEPTEMBER 30 December 31 2004 2003 ------------------------------- $ In thousands Segment assets $2,664,162 $2,413,043 =============================== Net reserve for losses $1,472,823 $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, and market factors, such as the entry or exit of a competitor in a given market, may also affect written premiums from period to period. Since our policies do not all renew in any given specific period, such changes may have a more pronounced effect in one period as compared to another. Premiums written for the professional liability segment increased by $14.9 for the three months and $26.9 million for the nine months ended September 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 third quarter have been at rates that are approximately 23% higher than expiring rates. On average, renewals during the nine months ended September 30, 2004 have been at rates that are approximately 20% higher than expiring rates. Rate increases on 2003 renewals, on average, were at rates that were 28% higher than expiring rates. We completed our conversion from occurrence policies to claims-made policies by the end of our third quarter and a majority of our occurrence policyholders accepted the conversion to claims-made coverage. First-year claims-made coverage has a significantly lower premium than occurrence coverage due to lower loss exposure, and accordingly, over the past year, our renewal premiums on those renewing policies were lower. Claims-made policies step through an increasing rate progression from first-year to mature, generally over a five-year period. This increasing rate progression is the result of our increasing exposure to loss. Accordingly, during the period of rate progression, all else being equal, our premiums and our losses will increase. Premiums earned Premiums earned for the professional liability segment increased $6.3 million for the three months and $39.4 million for the nine months ended September 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 $1.2 million and $8.9 million for the three and nine month periods ended September 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. Also, some insured risks are purchasing lower policy limits due to higher premium rates. 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 nine month periods ended September 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 nine month periods ended September 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 nine month periods ended September 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 Nine Months Ended September 30 September 30 ------------------------------ ----------------------------- 2004 2003 2004 2003 ------------------------------------------------------------ $ In thousands Net losses: Current accident year $116,682 $116,140 $339,701 $317,392 Change in prior accident years net losses - - - 750 ------------------------------------------------------------ Calendar year net losses $116,682 $116,140 $339,701 $318,142 ============================================================ Net loss ratio attributable to: Current accident year 90.3% 95.5% 91.0% 97.7% Change in prior accident years losses - - - 0.2% ------------------------------------------------------------ Calendar year net loss ratio 90.3% 95.5% 91.0% 97.9% ============================================================
The 2004 current accident year net loss ratios are lower than the 2003 ratios primarily because loss costs, while continuing to increase, have increased at a slower pace than premium rates. Loss ratios have also improved because we converted our occurrence policies to claims-made coverage as discussed under premiums. Initial loss ratios associated with claims-made coverage are generally lower than those associated with occurrence coverage. 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 $3.9 million and $9.0 million, respectively, for the three and nine month periods ended September 30, 2004 as compared to the same periods in 2003. The increase in investment income primarily resulted from higher average invested funds in 2004, but also reflects some improvement in the yield of our fixed maturity portfolio. While prevailing market interest rates have remained historically low, changes in the duration and asset mix of the portfolio have helped to increase the yield. During the third quarter we have been able to invest some new and matured funds at yields that are above the average yield of our fixed maturity portfolio. The weighted average tax equivalent income yield of our professional liability segment fixed maturity investments is 4.5% for the three months and 4.4% for the nine months ended September 30, 2004 as compared to 4.4% and 4.7%, respectively, for the same three and nine month periods in 2003. Net realized investment gains consist primarily of 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 gains or losses from such sales vary from period to period. The components of net realized investment gains in both 2004 and 2003 are shown in the following table.
Three Months Ended Nine Months Ended September 30 September 30 ------------------------------ ----------------------------- 2004 2003 2004 2003 ------------------------------------------------------------ $ In thousands Net gains (losses) from sales $1,717 $ 1,428 $ 4,603 $ 4,362 Other-than-temporary impairment losses - - - (322) Holding gains (losses) on trading portfolio 8 3 5 3 ------------------------------------------------------------ Net realized investment gains (losses) $1,725 $ 1,431 $4,608 $ 4,043 ============================================================
28 Underwriting, Acquisition and Insurance Expenses Underwriting, acquisition and insurance expenses increased by $2.7 million and $7.8 million, respectively, for the three and nine month periods ended September 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 primarily reflects higher variable costs incurred as a result of premium growth but also includes higher costs for salaries, benefits, and higher professional fees related to Sarbanes-Oxley compliance. 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 (refunds) were approximately $46,000 and $329,000, respectively, for the three and nine month periods ended September 30, 2004 as compared to approximately $(173,000) and $51,000 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 Nine Months Ended September 30 Increase September 30 Increase ------------------------ ------------------------- 2004 2003 (Decrease) 2004 2003 (Decrease) ------------------------------------------------------------------------------- $ In thousands Revenues: Gross premiums written $57,351 $51,224 $6,127 $162,101 $145,874 $16,227 =============================================================================== Net premiums written $49,918 $46,494 $3,424 $142,636 $132,918 $ 9,718 =============================================================================== Premiums earned $53,597 $48,479 $5,118 $155,201 $139,168 $16,033 Less: Premiums ceded 7,426 4,725 2,701 19,452 12,938 6,514 ------------------------------------------------------------------------------- Net premiums earned 46,171 43,754 2,417 135,749 126,230 9,519 Net investment income 2,645 2,612 33 7,942 7,644 298 Net realized investment gains (losses) 14 5 9 65 106 (41) Other income 566 549 17 1,809 1,541 268 ------------------------------------------------------------------------------- Total revenues 49,396 46,920 2,476 145,565 135,521 10,044 ------------------------------------------------------------------------------- Expenses: Loss and loss adjustment expenses 37,667 45,083 (7,416) 111,151 130,096 (18,945) Less: Reinsurance recoveries 10,068 15,440 (5,372) 27,872 46,107 (18,235) ------------------------------------------------------------------------------- Net losses and loss adjustment expenses 27,599 29,643 (2,044) 83,279 83,989 (710) Underwriting, acquisition and insurance expenses 11,301 10,078 1,223 31,251 28,436 2,815 ------------------------------------------------------------------------------- Total expenses 38,900 39,721 (821) 114,530 112,425 2,105 ------------------------------------------------------------------------------- Income before income taxes and minority interest $10,496 $ 7,199 $3,297 $ 31,035 $ 23,096 $ 7,939 =============================================================================== Net Loss ratio * 59.8% 67.7% (7.9%) 61.3% 66.5% (5.2%) Underwriting expense ratio * 24.5% 23.0% 1.5% 23.0% 22.5% 0.5% ------------------------------------------------------------------------------- Combined ratio 84.3% 90.7% (6.4%) 84.3% 89.0% (4.7%) Less: Investment income ratio * 5.7% 6.0% (0.3%) 5.9% 6.1% (0.2%) ------------------------------------------------------------------------------- Operating ratio 78.6% 84.7% (6.1%) 78.4% 82.9% (4.5%) ===============================================================================
* Ratios shown are expressed as a percentage of net premiums earned. SEPTEMBER 30 December 31 2004 2003 ------------------------------- $ In thousands Segment assets $ 480,411 $ 431,264 =============================== Net reserves for losses $ 72,288 $ 71,315 =============================== 30 Premiums Premium revenues are almost entirely comprised of auto and homeowners premiums with auto premiums being the primary revenue source. Written and earned premiums are higher in both the three and the nine month periods as compared to 2003 primarily due to increases in the number and value of insured autos and homes. Premiums also grew because of small rate increases implemented during 2004 and 2003. On both a written and an earned basis, gross and ceded premiums also increased due to higher mandatory state-wide assessments charged by the Michigan Catastrophic Claims Association (MCCA), a non-profit organization established by the Michigan legislature and one of our largest reinsurers. These assessments are included in our premium rate structure. Losses and Loss Adjustment Expenses The improvement in our current accident year net loss ratio (current accident year net losses divided by calendar year net premiums earned) for the three months ended September 30, 2004 as compared to the ratio for the same period in 2003, is primarily due to lower homeowners loss costs. Homeowners loss costs were higher in the third quarter of 2003 due to property damage claims related to the August 2003 Midwest power outage and a high number of fire claims. The improvement in the current accident year net loss ratio for the nine months ended September 30, 2004 as compared to the same period in 2003 is due both to a reduction in the number of auto collision and comprehensive claims incurred in 2004 relative to the level of premiums earned and higher homeowners losses in 2003, as discussed above. 2004 2003 ---------------------------- $ In thousands Three months ended September 30 ------------------------------ Current accident year net loss ratio 67.2% 76.0% Favorable loss reserve development $ 3,417 $ 3,646 Nine months ended September 30 ------------------------------ Current accident year net loss ratio 67.9% 72.1% Favorable loss reserve development $ 8,911 $ 7,106 As a result of favorable development related to the frequency and severity of prior years' auto liability reserves, we reduced prior accident years' net losses during both 2004 and 2003. Reinsurance recoveries in 2003 were greater than normal due to a reevaluation of automobile personal injury losses for prior coverage years which were ceded to the MCCA. Net Investment Income and Net Realized Investment Gains (Losses) Our net investment income, which is comprised of the interest and dividend income from our fixed maturity, short-term, cash equivalents and equity investments, net of investment expenses, has not changed significantly as compared to 2003. Net realized investment gains (losses) do not include any other-than-temporary impairments in either 2004 or 2003. Underwriting, acquisition and insurance expenses Our underwriting expense ratio (underwriting, acquisition and insurance expenses divided by net premiums earned) is 24.5% and 23.0% for the three and nine month periods ended September 30, 3004 as compared to 23.0% and 22.5% for the same respective periods in 2003. The increase in the 2004 ratios primarily reflects higher professional fees related to Sarbanes-Oxley compliance. 31 REVENUE AND EXPENSE NOT ATTRIBUTED TO SEGMENTS Revenues and expenses not attributed to our operating segments are summarized below.
Three Months Ended Nine Months Ended September 30 September 30 ----------------------- -------------------- 2004 2003 2004 2003 -------------------------------------------------- $ In thousands Investment revenues directly earned by the parent holding company: Net investment income $ 534 $ 106 $ 681 $ 175 Net realized investment gains 1,324 - 2,673 - -------------------------------------------------- 1,858 106 3,354 175 -------------------------------------------------- Loss on early extinguishment of debt - 305 - 305 Interest expense on debt 1,902 1,188 4,537 2,257 -------------------------------------------------- Corporate (loss) not attributed $ (44) $(1,387) $(1,183) $(2,387) to segments ==================================================
The increase in net investment income is primarily attributable to the investment of the net proceeds from issuance of the trust preferred securities of $44.9 million. Interest expense increased for the third quarter of 2004 as compared to 2003 because we issued additional debt in April and May of 2004 (the Subordinated Debentures). In the first six months of 2003, our only outstanding debt was a bank term loan which was lower in amount and carried a lower rate than the Convertible Debentures issued in July, 2003. Interest expense is higher for the nine month period of 2004 because we increased our average amount of outstanding debt and paid higher interest rates. RECENT ACCOUNTING PRONOUNCEMENTS AND GUIDANCE On October 13, 2004, the FASB concluded that Statement 123R, "Share Based Payments" which would require companies to measure compensation cost for all share-based payments, including employee stock options, would be effective for public companies for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of Statement 123 and Statement 123R to the beginning of the fiscal year that includes the effective date would be permitted, but not required. Early adoption of Statement 123R is encouraged. The FASB is expected to issue Statement 123R during the 2004 fourth quarter. We have not estimated the effect that Statement 123R will have on our results of operations. In September, 2004 the Emerging Issues Task Force of the FASB reached a consensus regarding Issue 04-08-"Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted EPS". Under current interpretations of SAFS 128, Earnings Per Share, issuers of contingently convertible debt instruments (Co-Cos) exclude the potential common shares underlying the Co-Co (the Co-Co shares) from the calculation of diluted earnings per share until the market price or other conversion contingency is met. Currently our diluted earnings per share computations do not include the Co-Co shares because the market price contingency has not been met. Under the new consensus, Co-Co shares are to be included in diluted earnings per share computations (if dilutive) regardless of whether the market price contingency has been met. The consensus is expected to become effective for financial statements ending after December 15, 2004 and is to be retroactively applied to all periods presented. The expected effect of the new guidance is shown below.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 SEPTEMBER 30 -------------------------- ------------------------- 2004 2003 2004 2003 ------------ ------------- ------------ ------------ Diluted EPS, no inclusion of Co-Co shares $ 0.66 $ 0.33 $ 1.75 $ 0.85 ==================================================== Diluted EPS, Co-Co shares included $ 0.65 $ 0.33 $ 1.71 $ 0.85 ====================================================
32 We have not included Co-Co shares in the revised diluted EPS calculations for the nine month period ended September 30, 2003 because the effect would be anti-dilutive. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The term market risk refers to the risk of loss arising from adverse changes in market rates and prices, such as interest rates, equity prices and foreign currency exchange rates. We believe that we are principally exposed to three types of market risk related to our investment operations: interest rate risk, credit risk and equity price risk. Fixed maturity securities comprise more than 89% of our total investments at September 30, 2004. Fixed maturity securities are subject primarily to interest rate risk and credit risk and we believe these risks represent our most significant exposures to market risk. INTEREST RATE RISK Fluctuations in interest rates have a direct effect on the fair value of fixed maturity securities. As interest rates rise, market values of fixed income portfolios fall and vice versa. The table below displays the anticipated effect of market interest rate fluctuations on the value and weighted average modified duration of our fixed maturity portfolio (dollars in millions).
SEPTEMBER 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 $1,953 $ (169) 4.34 $1,664 3.73 100 basis point rise $2,037 $ (85) 4.18 $1,727 3.63 Current rate * $2,122 $ - 3.97 $1,791 3.54 100 basis point decline $2,205 $ 83 3.75 $1,854 3.45 200 basis point decline $2,290 $ 168 3.71 $1,919 3.52
*Current rates are as of September 30, 2004 and December 31, 2003, as indicated. 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. All of our fixed maturity securities are classified as available-for-sale. Fluctuations in the fair value of these securities, unless considered to be other-than-temporary in nature, are reported, net of tax effects, as a component of stockholders equity. At September 30, 2004, our available-for-sale equity investments included preferred stocks having a fair value of approximately $21.5 million. Because preferred stocks bear fixed rates of return, they are also subject to interest rate risk. Our cash and short-term investment portfolio is included in our consolidated balance sheet on a cost basis which approximates its fair value. This portfolio lacks significant interest rate sensitivity due to its short duration. 33 CREDIT RISK Our fixed income securities are also subject to credit risk. We control this exposure by emphasizing investment grade credit quality in the fixed income securities we purchase. As of September 30, 2004, over 99.9% of our fixed income portfolio consisted of securities rated investment grade. We believe that this concentration in investment grade securities reduces our exposure to credit risk on these fixed income investments to an acceptable level. However, in the current environment even investment grade securities can rapidly deteriorate and result in significant losses. EQUITY PRICE RISK At September 30, 2004 the fair value of our investment in common stocks was $14.1 million, $12.8 million of which is considered to be available-for-sale and $1.3 million of which is considered to be in a trading portfolio. Common stocks 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 September 30, 2004 would increase the fair value of these securities to $15.5 million; a hypothetical 10% decrease in the price of each of these marketable securities would reduce the fair value to $12.7 million. The selected hypothetical change does not reflect what could be considered the best or worst scenarios. Declines in the fair value of available-for-sale securities that we determine to be other-than-temporary reduce net income in the then current period. Changes in the fair values of trading securities, whether gains or losses, are included in net income in the then current period. ITEM 4. CONTROLS AND PROCEDURES The Chief Executive Officer and Chief Financial Officer of the Company evaluated the effectiveness of our disclosure controls and procedures (as defined in SEC Rule 13a-15(e)) as of September 30, 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 September 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. 34 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. 35 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. 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 August 9, 2004 that furnished the information publicly released regarding its announcement of the company's results for the quarter period and six month period ended June 30, 2004. 36 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PROASSURANCE CORPORATION November 5, 2004 /s/ Howard H. Friedman ----------------------------------------- Howard H. Friedman, Chief Financial Officer (Duly authorized officer and principal financial officer)
37 EX-31.1 2 g91593exv31w1.txt SECTION 302 CERTIFICATION OF THE PEO EXHIBIT 31.1 CERTIFICATION I, A. Derrill Crowe, certify that: 1. I have reviewed this report on Form 10-Q of ProAssurance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15 (e)) and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 5, 2004 /s/ A. Derrill Crowe, M.D. ------------------------------ A. Derrill Crowe, M.D. Chief Executive Officer EX-31.2 3 g91593exv31w2.txt SECTION 302 CERTIFICATION OF THE PFO EXHIBIT 31.2 CERTIFICATIONS I, Howard H. Friedman, certify that: 1. I have reviewed this report on Form 10-Q of ProAssurance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15 (e)): a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 5, 2004 /s/ Howard H. Friedman --------------------------- Howard H. Friedman Chief Financial Officer EX-32.1 4 g91593exv32w1.txt SECTION 906 CERTIFICATION OF THE PEO EXHIBIT 32.1 A signed original of this written statement required by Section 906 has been provided to ProAssurance Corporation and will be retained by ProAssurance Corporation and furnished to the Securities and Exchange Commission or its staff upon request. CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of ProAssurance Corporation (the "Company") on Form 10-Q for the quarter ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, A. Derrill Crowe, M.D., Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ A. Derrill Crowe, M.D ----------------------------------------- A. Derrill Crowe, M.D. Chief Executive Officer November 5, 2004 EX-32.2 5 g91593exv32w2.txt SECTION 906 CERTIFICATION OF THE PFO EXHIBIT 32.2 A signed original of this written statement required by Section 906 has been provided to ProAssurance Corporation and will be retained by ProAssurance Corporation and furnished to the Securities and Exchange Commission or its staff upon request. CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of ProAssurance Corporation (the "Company") on Form 10-Q for the quarter ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Howard H. Friedman, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Howard H. Friedman ----------------------------------- Howard H. Friedman Chief Financial Officer November 5, 2004 -----END PRIVACY-ENHANCED MESSAGE-----