ITEM 1. BUSINESS
GENERAL
SCPIE Holdings Inc. (SCPIE Holdings) is a holding company owning subsidiaries licensed to provide insurance and reinsurance products. The Company is primarily a provider of medical malpractice insurance and related liability insurance products to physicians, oral surgeons, healthcare facilities and others engaged in the healthcare industry in California and Delaware. Previously, the Company had also been actively engaged in hospital and dental liability insurance, medical malpractice insurance and related products in other states and the global assumed reinsurance business. Since 2002, the assumed reinsurance business, hospital and dental business and medical malpractice insurance business outside its core states of California and Delaware have been in run-off.
The Company conducts its insurance business through three insurance company subsidiaries. The largest, a wholly owned subsidiary, SCPIE Indemnity Company (SCPIE Indemnity) is licensed to conduct direct insurance business only in California, its state of domicile. American Healthcare Indemnity Company (AHI), domiciled in Delaware, is licensed to transact insurance in 47 states and the District of Columbia. American Healthcare Specialty Insurance Company (AHSIC), domiciled in Arkansas, is eligible to write policies as an excess and surplus lines insurer in 20 states and the District of Columbia. AHI and AHSIC are wholly owned subsidiaries of SCPIE Indemnity. The Company also has an insurance agency subsidiary, SCPIE Insurance Services, Inc., two subsidiary corporations providing management services, and a corporate member of Lloyd’s of London (Lloyd’s), SCPIE Underwriting Limited, which is owned by SCPIE Indemnity.
The Company was founded in 1976 as the Southern California Physicians Insurance Exchange (the Exchange), a California reciprocal insurance company, and for the next 20 years conducted its operations as a policyholder-owned California medical malpractice insurance company. SCPIE Holdings was organized in Delaware in 1996 and acquired the business of the Exchange and the three insurance company subsidiaries in a reorganization that was consummated on January 29, 1997. The policyholders of the Exchange became the stockholders of SCPIE Holdings in the reorganization, and SCPIE Holdings concurrently sold additional shares of common stock in a public offering. The common stock of SCPIE Holdings is listed on the New York Stock Exchange under the trading symbol “SKP.”
For purposes of this annual report on Form 10-K, the “Company” refers to SCPIE Holdings and its subsidiaries. The term “Insurance Subsidiaries” refers to SCPIE Indemnity, AHI and AHSIC.
The Company’s website address is www.scpie.com. The Company makes available free of charge through its website the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material has been electronically filed with or furnished to the Securities and Exchange Commission. The Company also makes available on its website its corporate charter documents and corporate governance documents. Information contained on the Company’s website is not incorporated into and does not constitute a part of this annual report on Form 10-K. The Company’s website address referenced above is intended to be an inactive textual reference only and not an active hyperlink to the Company’s website.
Proposed Merger with The Doctors Company
On October 15, 2007, the Company agreed to be acquired by The Doctors Company for $28.00 in cash for each outstanding share of Company common stock in a merger transaction valued at approximately $281.1 million. The merger is subject to customary closing conditions, including, among others, (i) the approval of the merger by the holders of a majority in voting power of the outstanding common stock of the Company; (ii) the approval of the merger by the Departments of Insurance of California, Delaware and Arkansas; (iii) the receipt of antitrust approvals, or the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; and (iv) the absence of any order or injunction prohibiting the consummation of the merger. The Company currently expects the merger to close during the first half of 2008. However, it is possible that factors outside of the Company’s control could require the parties to complete the proposed merger at a later time or not to complete it at all.
INFORMATION ABOUT OPERATIONS
The Company’s insurance operations have historically been reported in two business segments: direct healthcare liability insurance and assumed reinsurance. Since 2002, the Company has focused its business operations on writing direct insurance in
its core direct healthcare liability insurance markets of California and Delaware. In direct insurance activities, the insurer assumes the risk of liability or loss from persons or organizations that are directly subject to the risks. In assumed reinsurance, the reinsurer assumes all or a portion of the risk directly covered by another insurer. Such risks may relate to liability (or casualty), property, life, accident, health, financial and other perils that may arise from an insurable event. Since 2002, the Company has been actively disengaging from the assumed reinsurance business.
The direct healthcare liability insurance operations are comprised of core and non-core business components. The Company’s core business principally represents its direct healthcare liability insurance business in California and Delaware, excluding a dental program managed by a national independent insurance agency Brown & Brown, Inc. (Brown & Brown), and hospital business. The Company’s non-core business represents its direct healthcare liability business outside of California and Delaware and the above mentioned dental program and all hospital business. The non-core business is in run-off and no new or renewal policies have been issued since March 6, 2003. See “Management’s Discussion and Analysis of Financial Conditions and Results of Operations.”
The Insurance Subsidiaries are rated B+ (Good) by A.M. Best Company (A.M. Best), the leading rating organization for the insurance industry.
DIRECT HEALTHCARE LIABILITY CORE INSURANCE OPERATIONS
Overview and Developments During 2007-Core Business
The Company has been a leading provider of medical malpractice insurance to physicians, oral surgeons and healthcare providers and facilities in California for many years. In 2001, the Company undertook the insurance of physicians in Delaware through a single Delaware broker. During 2007, the Company had net premiums earned under policies issued to California insureds representing 96.9% of the total net premiums earned in its core business component of the direct healthcare liability insurance operations.
The Company has also developed and markets ancillary liability insurance products for the healthcare industry, including directors and officers liability insurance for healthcare entities, errors and omissions coverage for managed care organizations and billing errors and omissions coverage for the medical profession. These represent a small part of the Company’s business.
The 2007 operations improved over 2006 due primarily to re-estimations of previous years’ loss and LAE reserves that had a favorable impact on the calendar year loss ratio in 2007. The 2006 operations were relatively stable compared to 2005. No rate increases were taken and a further decline in claims frequency offset severity increases. The following table displays the core business results for the years ended December 31, 2007, 2006 and 2005:
Core Direct Healthcare Liability Insurance Operations
Underwriting Results
(In Thousands)
Products
In its core direct healthcare liability operations, the Company underwrites professional and related liability policy coverages for physicians (including oral and maxillofacial surgeons), physician medical groups and clinics, managed care organizations and other providers in the healthcare industry. The following table summarizes the premiums earned by product in the Company’s core business for the periods indicated:
Premiums Earned in Core Business
(In Thousands)
Physician and Medical Group Professional Liability-Professional liability insurance for sole practitioners and for medical groups provides protection against the legal liability of the insureds for such things as injury caused by, or as a result of, the performance of patient treatment, failure to treat a patient and failure to diagnose an illness or injury. The Company offers separate policy forms for physicians who are sole practitioners and for those who practice as part of a medical group or clinic. The policy issued to sole practitioners includes coverage for professional liability that arises in the medical practice and may also include coverages for certain other “premises” liabilities that may arise in the non-professional operations of the medical practice, such as slip-and-fall accidents, and a limited defense reimbursement benefit for proceedings instituted by state licensing boards and other governmental entities.
The policy issued to medical groups and their physician members includes not only professional liability coverage and defense reimbursement benefits, but also substantially more comprehensive coverages for commercial general liability and employee benefit program liability and also provides a small medical payment benefit to injured persons. The business liability coverage included in the medical group policy includes coverage for certain employment-related liabilities and for pollution, which are normally excluded under a standard commercial general liability form. The Company also offers, as part of its standard policy forms for both sole and group practitioners, optional excess personal liability coverage for the insured physicians. Excess personal liability insurance provides coverage to the physician for personal liabilities in excess of amounts covered under the physician’s homeowner’s and automobile policies. The Company has developed a nonstandard program that may exclude business liability coverages.
The professional liability coverages are issued primarily on a “claims-made and reported” basis. Coverage is provided for claims reported to the Company during the policy period arising from incidents that occurred at any time the insured was covered by the policy. The Company also offers “tail coverage” for claims reported after the expiration of the policy for occurrences during the coverage period. The price of the tail coverage is based on the length of time the insured has been covered under the Company’s claims-made and reported policy. The Company provides free tail coverage for insured physicians who die or become disabled during the coverage period of the policy and those who have been insured by the Company for at least five consecutive years and retire completely from the practice of medicine. Free tail coverage is automatically provided to physicians with at least five consecutive years of coverage with the Company and who are also at least 65 years old.
Business liability coverage for medical groups and clinics and the excess personal liability insurance are underwritten on an occurrence basis. Under occurrence coverage, the coverage is provided for incidents that occur at any time the policy is in effect, regardless of when the claim is reported. With occurrence coverage, there is no need to purchase tail coverage.
The Company offers standard limits of insurance up to $5.0 million per claim or occurrence, with up to a $10.0 million aggregate policy limit for all claims reported or occurrences for each calendar year or other 12-month policy period. The most common limit is $1.0 million per claim or occurrence, subject to a $3.0 million aggregate policy limit. The Company’s limit of liability under the excess personal liability insurance coverage is $1.0 million per occurrence with no aggregate limit. The defense reimbursement benefit for governmental proceedings is $25,000, and the medical payments benefit for persons injured in non-professional activities is $10,000.
Healthcare Provider Liability/Healthcare Facility Liability-The Company offers its professional liability coverage to a variety of specialty provider organizations, including outpatient surgery centers, medical urgent care facilities, hemodialysis, clinical and pathology laboratories and, on a limited basis, hospital emergency departments. The Company also offers its professional liability coverage to healthcare providers such as chiropractors, podiatrists and nurse practitioners. These policies include the standard professional liability coverage provided to physicians and medical groups, with certain modifications to meet the special needs of these healthcare providers. The policies are generally issued on a claims-made and reported basis with the limits of liability up to those offered to larger medical groups. The limits of coverage under the current healthcare provider policies issued by the Company are between $1.0 million and $5.0 million per incident, subject to $3.0 million to $5.0 million aggregate policy limits.
Ancillary Liability Products-The Company offers a policy for managed care organizations that provides coverage for liability arising from covered managed care incidents or vicarious liability for medical services rendered by non-employed physicians. Covered services include peer review, healthcare expense review, utilization management, utilization review and claims and benefit handling in the operation of the managed care organizations. These policies are generally issued on a claims-made and reported basis. The annual aggregate limit of coverage under the current managed care organization policies issued by the Company is $1.0 million. The Company offers directors and officers’ liability policies to medical providers. The directors and officers’ liability policies are generally issued on a claims-made and reported basis. The limit of coverage on directors and officers’ liability policies written by the Company is $1.0 million. The Company also offers a policy that provides physicians and medical groups with protection for defense expenses and certain liabilities related to governmental investigations into billing errors and omissions to Medicare and other government-subsidized healthcare programs.
Marketing and Policyholder Services
Initially, the Company marketed its physician professional liability policies directly to physicians and medical groups in California. Infrequently, larger medical groups were written through insurance brokers. During the past several years, brokered business has become a more important source of business in California. In Delaware, the Company markets its policies through a single broker.
The following tables set forth core healthcare liability policies sold directly to the insured and through brokers:
Core Healthcare Liability
(In Thousands)
The Company’s Marketing Department consists of a Senior Vice President in charge of both marketing and underwriting, and approximately 15 employees who directly solicit prospective policyholders, maintain relationships with existing insureds and provide marketing support to brokers. The Company’s marketing efforts include sponsorship by local medical associations, educational seminars, advertisements in medical journals and direct mail solicitation to licensed physicians and members of physician medical specialty group organizations.
The Company attracts new physicians through special rates for medical residents and discounts for physicians just entering medical practice. In addition, the Company sponsors and participates in various medical group and healthcare administrator programs, medical association and specialty society conventions and similar programs that provide visibility in the healthcare community.
The Company’s current marketing emphasis is directed almost entirely toward California physicians and medical groups. The Company conducts its marketing efforts from its principal office in Los Angeles.
Underwriting
The Underwriting Department consists of the Senior Vice President, two divisional underwriting managers, 10 underwriters and six technical and administrative assistants. The Company’s Underwriting Department is responsible for the evaluation of applicants for professional liability and other coverages, the issuance of policies and the establishment and implementation of underwriting standards for all of the coverages underwritten by the Company. Certain of these underwriters specialize in underwriting managed care organizations and directors and officers’ liability products.
The Company performs a continuous process of reunderwriting its insured physicians, medical groups and healthcare facilities. Information concerning insureds with large losses, a high frequency of claims or unusual practice characteristics is developed through claims and risk management reports or correspondence.
Rates
The Company establishes, through its own actuarial staff and independent actuaries, rates and rating classifications for its physician and medical group insureds based on the Company’s loss and loss adjustment expense (LAE) experience developed over the past 10 years and upon rates charged by its competitors. The Company has various rating classifications based on practice, location, medical specialty, limits and other factors. The Company utilizes various discounts, including discounts for part-time practice, physicians just entering medical practice and large medical groups. The Company has developed nonstandard programs for physicians who have unfavorable loss history or practice characteristics, but whom the Company considers insurable. Policies issued in this program have significant surcharges. The Company has established its premium rates and rating classifications for managed care organizations utilizing data publicly filed by other insurers, and based in part on its own experience. The data for managed care organization errors and omissions liability is extremely limited, as tort exposures for these organizations are only recently beginning to develop. The rates for directors and officers’ liability are developed using historical data publicly filed by other insurers, financial analysis and loss history. All rates for liability insurance in California are subject to the prior approval of the Insurance Commissioner.
The Company has instituted annual overall rate increases in California during the past 10 years ranging from approximately 3.5% to 10.6%. Rate increases of 9.9% and 6.5% were approved and implemented in California effective October 1, 2003, and January 1, 2005, respectively. The Company did not request any rate change in California for 2006, 2007 or 2008. Rate increases of 13.3% and 19.2% were approved in Delaware effective July 15, 2004 and 2005, respectively. Approximately 23% of the Company’s in force premium as of December 31, 2007 is evaluated using experience rating formulas and therefore is not necessarily subject to base rate changes. Experience rating formulas are sensitive to the individual loss experience of groups of physicians and may produce increases or decreases different than the change in the general base rate. In general, in force premiums for experience rated policies has been declining in the last three years as frequency of claims has declined. See “Risk Factors-Rate Increases in California.”
Claims
The Company’s Claims Department is responsible for claims investigation, establishment of appropriate case reserves for losses and LAE, defense planning and coordination, control of attorneys engaged by the Company to defend a claim and negotiation of the settlement or other disposition of a claim. Under most of the Company’s policies, except managed care organization errors and omissions policies, and directors and officers’ liability policies, the Company is obligated to defend its insureds, which is in addition to the limit of liability under the policy. Medical malpractice claims often involve the evaluation of highly technical medical issues, severe injuries and conflicting expert opinions. In almost all cases, the person bringing the claim against the physician is already represented by legal counsel when the Company is notified of the potential claim.
The Claims Department staff includes a Senior Vice President in charge of Claims, an assistant claims manager, unit managers, litigation supervisors, investigators and other experienced professionals trained in the evaluation and resolution of medical professional liability and general liability claims. The Claims Department staff consists of approximately 20 employees. The Company has unit managers and branch managers responsible for specific geographic areas, and additional units for specialty areas such as healthcare facilities, birth injuries and policy coverage issues. The Company also occasionally uses independent claims adjusters, primarily to investigate claims in remote locations. The Company selects legal counsel from among a group of law firms in the geographic area in which the action is filed.
The Company vigorously defends its insureds against claims, but seeks to expediently resolve cases with high-exposure potential. The defense of a healthcare professional liability claim requires significant cooperation between the litigation supervisor or claims manager responsible for the claim and the insured physician. In California and other states, the law requires that a healthcare professional liability claim cannot generally be settled without the consent of the insured. California law requires that the insurer report such settlements of more than $30,000 to a medical disciplinary board, and federal law requires that any claim payment, regardless of amount, be reported to a national data bank, which can be accessed by various state licensing and disciplinary boards and medical peer evaluation committees. Thus, the physician or other healthcare professional is often placed in a difficult position of knowing that a settlement may result in the initiation of a disciplinary proceeding or some other impediment to his or her ability to practice. The Claims Department supervisor must be able to fully evaluate considerations of settlement or trial and to communicate effectively the Company’s recommendation to its insured. If the insured will not consent to a settlement offer, the Company may be exposed to its policy limit if the case proceeds to trial.
The Company also maintains a risk management staff, including a department manager and two members. The Risk Management Department works directly with medical groups and individual insureds to improve their procedures in order to minimize the incidence of claims.
BUSINESS OPERATIONS IN RUN-OFF
Direct Healthcare Liability Insurance Operations in Run-Off
The Company formerly offered a number of direct healthcare liability insurance programs outside its core business. These programs were all discontinued and no policies were issued or renewed after March 2003. However, there are outstanding policy claims to be resolved under these programs. The principal programs involved hospitals, some nonstandard physician programs and physician and dentist programs administered by Brown & Brown.
Hospital Programs-In 1996, the Company undertook an expansion plan which included products that offered comprehensive hospital and related liability coverages for individual hospitals and large healthcare systems. These policies were written through national and regional brokers and covered facilities in four states, in addition to California. The Company encountered intense price competition and incurred material adverse loss experience under many of its large hospital and other healthcare facility policies. As a result, the Company began to non-renew a number of its hospital policies or offered renewal only at substantially increased premium rates. The last hospital policy expired in December 2002.
Physician Programs Outside of California and Delaware-The Company undertook a major geographic expansion in the physician and small medical group market through an arrangement with Brown & Brown. This arrangement commenced January 1, 1998, and eventually encompassed nine states, the largest in terms of premium volume being Connecticut, Florida and Georgia. During 2000, the Company entered into a separate arrangement with Brown & Brown covering the California and Texas portion of a dental liability program developed by Brown & Brown. The Company also reinsured the entire risk of policies issued nationally by another insurer to oral and maxillofacial surgeons marketed by Brown & Brown.
The Company and Brown & Brown agreed in March 2002 to terminate both the physician and dental programs no later than March 2003, and as of March 2004, all policies had expired.
Current Status
The Company continues to settle and close the claims associated with the direct healthcare liability business in run-off. As of December 31, 2007, non-core healthcare liability reserves accounted for 6.9% of the Company’s total net reserves. The following table shows the progress the Company has achieved in the disposition of these claims over the last three years.
Direct Healthcare Liability Claims in Run-Off:
(Dollars in Thousands)
New claims currently arise principally from tail policies which were required by regulation to be offered upon cancellation and expiration of the underlying policy. The Company continues to settle claims at amounts it considers reasonable and defends against claims it considers non-meritorious. The Company’s average reserves held on open claims have increased as smaller claims tend to settle earlier in the claims settlement process.
Assumed Reinsurance Operations In Run-Off
In August 1999, the Company established a separate Assumed Reinsurance Division under the direction of two senior officers. The principal reinsurance programs included casualty, property, accident and health and workers’ compensation and marine programs.
Reinsurance is an arrangement in which an insurance company, the reinsurer or the assuming company, agrees to indemnify another insurance company, the reinsured or the ceding company, against all or a portion of the insurance risks underwritten by the ceding company under one or more insurance contracts. The Company concentrated the majority of its assumed reinsurance portfolio on treaty reinsurance. Treaty reinsurers, including the Company, do not separately evaluate each of the individual risks assumed under their treaties and, consequently, after a review of the ceding company’s underwriting practices, are largely dependent on the original risk underwriting decisions made by the ceding company. The Company also focused on pro rata, or quota share, arrangements, in which the ceding company bears a proportional share of the risk and therefore the incentive to underwrite and price the business appropriately.
Exit From Most Reinsurance Operations
The Company suffered significant losses in 2001 in its non-California healthcare operations and in its assumed reinsurance operations from the World Trade Center terrorist attack. These losses impacted the capital adequacy ratios under the A.M. Best and NAIC capital adequacy models and resulted in the reduction in the A.M. Best rating assigned to the Insurance Subsidiaries.
In order to reduce its capital requirements related to assumed reinsurance operations, the Company entered into a 100% quota share reinsurance agreement with Rosemont Re, under which the Company ceded almost all of its assumed earned reinsurance premiums after June 30, 2002, for the 2001 and 2002 underwriting years. This treaty relieved the Company of significant premium leverage and significantly improved the Company’s risk-based capital adequacy ratios under both the A.M. Best and NAIC models.
Under the terms of the treaty with Rosemont Re, there are no limitations on the amount of losses recoverable by the Company, and the treaty includes a profit-sharing provision should the combined ratio calculated on the base premium ceded be below 100%. The treaty requires Rosemont Re to reimburse the Company for its acquisition and administrative expenses. In addition, the Company was required to pay Rosemont Re additional premium in excess of the base premium ceded of 14.3%.
There are certain losses not included in the treaty with Rosemont Re, including any World Trade Center losses. Further, the treaty does not involve the assumption of any earned premium or losses attributable to periods prior to June 30, 2002, which remain the responsibility of the Company. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
After consummation of the Rosemont Re reinsurance treaty, the Company continued to participate during 2003 in one Lloyd’s syndicate that specialized in underwriting professional liability excess insurance. The Company’s decision to continue to support this syndicate was primarily due to the attractive increases in reinsurance rates in this segment of the market, as well as the significant capital costs involved in running off the business if the syndicate were terminated. This syndicate was commuted as of December 31, 2005 and the Company is no longer exposed to losses related to insureds of this syndicate.
Remaining Assumed Reinsurance Operations
The Company continues to administer claims and other matters relating to reinsurance treaties and contracts entered into by the Company, including those subject to the 100% quota share reinsurance treaty with Rosemont Re. At year-end 2007, 2006 and 2005, the principal net loss reserves retained by the Company under these treaties involved (i) occupational accident coverage and excess workers compensation benefits, which typically provides lifetime medical and related benefits at high coverage levels, (ii) excess of loss directors and officers liability reinsurance, (iii) bail and immigration bonds, and (iv) London-based business including Lloyd’s syndicates.
The following table presents the net assumed reinsurance reserves (including retrospective reserves ceded under the Rosemont Re Treaty of $5.7 million, $6.4 million, and $7.1 million, respectively) by major component as of December 31:
(1)
Additional net liabilities of $3.6 million representing payment requests made to the Company are included in other liabilities on the Company’s balance sheet. These net liabilities are being contested in pending arbitrations. (See “Legal Proceedings-Bail and Immigration Bond Proceedings.”)
The assumed reinsurance net reserves continue to decline as payments are made and reserves are settled or contracts are commuted. The Company, from time to time, commutes individual contracts to speed up the settlement process. Commutation requires an agreement between the insured and reinsurer whereby one payment by the reinsurer will settle all its remaining obligations. Such settlements normally include actuarial estimates of potential losses on an individual contract basis, fees, as well as the effect of the time value of money.
LOSS AND LOSS ADJUSTMENT EXPENSE (LAE) RESERVES
The determination of loss reserves is a projection of ultimate losses through an actuarial analysis of the claims history of the Company and other professional liability insurers, subject to adjustments deemed appropriate by the Company due to changing circumstances. Included in its claims history are losses and LAE paid by the Company in prior periods and case reserves for anticipated losses and LAE developed by the Company’s Claims Department as claims are reported and investigated. Actuaries rely primarily on such historical loss experience in determining reserve levels on the assumption that historical loss experience provides a good indication of future loss experience despite the uncertainties in loss cost trends and the delays in reporting and settling claims. As additional information becomes available, the estimates reflected in earlier loss reserves may be revised. Any increase in the amount of reserves, including reserves for insured events of prior years, could have an adverse effect on the Company’s results for the period in which the adjustments are made. See “Risk Factors-Loss and LAE Reserves.”
The loss and LAE reserves included in the Company’s financial statements represent the Company’s best estimate of the amounts that the Company will ultimately pay on claims, and the related costs of adjusting those claims, as of the date of the
financial statements. The uncertainties inherent in estimating ultimate losses on the basis of past experience have increased in recent years principally as a result of judicial expansion of liability standards and expansive interpretations of insurance contracts. These uncertainties may be further affected by, among other factors, changes in the rate of inflation and changes in the propensities of individuals to file claims. The inherent uncertainty of establishing reserves is relatively greater for companies writing liability insurance, including medical malpractice insurance, due primarily to the longer-term nature of the resolution of claims. There can be no assurance that the ultimate liability of the Company will not exceed the amounts reserved.
The Company relies on its internal actuarial staff in establishing its reserves. The Company’s internal actuarial staff reviews reserve adequacy on a quarterly basis. The Company continually refines reserve estimates as experience develops and further claims are reported and resolved. The Company reflects adjustments to reserves in the results of the periods in which such adjustments are made. The Company’s medical malpractice and assumed reinsurance insurance written are lines of business for which the initial loss and LAE estimates may be impacted by events occurring long after the claim is incurred. Such events include sudden severe inflation or adverse judicial or legislative decisions in medical malpractice insurance and the inherent long reporting delays in assumed reinsurance.
The Company’s actuaries use a variety of actuarial methodologies in evaluating the adequacy of healthcare liability loss and LAE reserves. Loss development methods use historical loss development patterns by the year a claim is reported (the report year) and the valuation points of reported losses during ensuing periods. Paid loss and reported incurred loss development projections are base methods and are used to support other techniques. Report year claim count and severity (average claim size) projections are developed to provide alternative projections using reported claim frequency and trended severity. Alternative reported projections are developed by adjusting the claims settlement rates so that these patterns are consistent from year to year. Trended pure premium projections are developed by trending average losses per exposure from mature periods and are considered the most consistent methods. The Company also uses the Bornhuetter-Ferguson method, a standard method which combines reported or paid losses, loss development or payment patterns and expected loss ratios.
The indications derived under the various methodologies are analyzed by limit, resulting average loss trends, the year in which the medical incident occurred or was reported and known policy limit claims outstanding. An individual reserve level is selected by report year or accident year in the case of occurrence coverages.
Loss development methods based on historical patterns as well as the Bornhuetter-Ferguson method, are sensitive to changes in the pattern of loss payments or reported losses. Methods which determine trends from mature periods are less sensitive to changes in loss payment or reporting patterns. In general, trended pure premium loss methodologies have been given more weight in selecting the levels for the most recent report years. As more data emerges in payments and settled claims, the various methodologies begin to converge.
In the assumed reinsurance area, the Company’s actuaries rely heavily on losses, including IBNR, reported by the ceding companies. The Company obtains analysis from the actuary of the ceding companies, when available. These analyses are reviewed by the Company’s actuaries as well as general industry patterns to determine the Company’s reserve position. The volatility is greatest in those areas in which claims take a long time, often many years, to be reported through the worldwide reinsurance market.
In connection with the reserve certification required under state statutory regulations, independent actuaries review the Company’s reserves for losses and LAE at the end of each fiscal year. The independent actuaries report includes a single point estimate of required reserve levels. The Company considers the independent actuaries work when determining reserve levels, but primarily as a validation that the Company’s reserve analysis is reasonable and has considered the relevant factors inherent in such a determination, such as, anticipated or estimated changes in the frequency and severity of claims, loss retention levels and premium rates.
The Company’s loss reserve experience is shown in the following table, which sets forth a reconciliation of beginning and ending reserves for unpaid losses and LAE for the years indicated:
The decreases during 2007, 2006 and 2005 in estimated losses and LAE occurring in prior years were primarily attributable to favorable loss experience in direct healthcare liability insurance due to the declining frequency in claims in those years and non-core direct healthcare liability insurance in 2005, partially offset by adverse experience in the assumed reinsurance business. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Overview.”
The following table reflects the development of loss and LAE reserves for the periods indicated at the end of that year and each subsequent year. The line entitled “Loss and LAE reserves” reflects the reserves, net of reinsurance recoverables, as originally reported at the end of the stated year. Each calendar year-end reserve includes the estimated unpaid liabilities for that report or accident year and for all prior report or accident years. The section under the caption “Cumulative net paid as of” shows the cumulative amounts paid related to the reserve as of the end of each subsequent year. The section under the caption “Liability reestimated as of” shows the original recorded reserve as adjusted as of the end of each subsequent year to reflect the cumulative amounts paid and all other facts and circumstances discovered during each year. The line “Net cumulative redundancy (deficiency)” reflects the difference between the latest reestimated reserve amount and the reserve amount as originally established.
The gross liability for losses before reinsurance, as shown on the balance sheet, and the reconciliation of that gross liability to amounts net of reinsurance are reflected below the table.
In evaluating the information in the table below, it should be noted that each amount includes the effects of all changes in amounts of prior periods. For example, if a loss determined in 2005 to be $100,000 was first reserved in 1995 at $150,000, the $50,000 redundancy (original estimate minus actual loss) would be included in the cumulative redundancy in each of the years 1995 through 2005 shown below. This table presents development data by calendar year and does not relate the data to the year in which the claim was reported or the incident actually occurred. Conditions and trends that have affected the development of these reserves in the past will not necessarily recur in the future.
Prior to the Company’s expansion outside of its California healthcare liability markets beginning in 1997, the Company had historically experienced favorable development in loss and LAE reserves established for prior years on both a gross and net basis. The Company believes that the favorable loss and LAE reserve development resulted from four factors: (i) the Company’s conservative approach of establishing reserves for medical malpractice insurance losses and LAE, (ii) the continuing benefits from the Medical Injury Compensation Reform Act (MICRA), the California tort reform legislation that was declared constitutional in a series of decisions by the California Supreme Court in the mid-1980s, (iii) benefits from California legislation requiring matters in litigation to proceed more expeditiously to trial, and (iv) improved results from a restructuring of the Company’s internal claims process. The Company believes, based on its analysis of annual statements filed with state regulatory authorities, that its principal California competitors experienced similar favorable loss and LAE reserve development in those years.
Core Healthcare Business
The Company’s reserve analysis (and its independent consulting actuaries’ analysis) began to exhibit less variability related to the core California healthcare liability business from 1999 forward as the effects of the items mentioned in the preceding paragraph were reflected in the historical loss and LAE data which is the foundation of actuarial estimates. As this variability decreased, the Company’s core business reserve estimates, although still considered conservative, were inherently less variable than before.
The ultimate results of the number of policy-limit losses which may occur in any single year or the ultimate effect litigation results may have on the average severity of losses, will not be known for several years. The majority of severe cases will not be settled in the twenty-four month period following reporting of the claim. The Company has continued its historical policy of estimating the current year’s incurred losses in a manner designed to protect against unfavorable trends in large losses or severity.
This policy, along with a significant decrease in the frequency of claims (a cumulative 35.1% over the last four years) has allowed favorable development in the core healthcare reserves of between 5.9% and 10.0% of the preceding year-end net reserve balances. Frequency has stabilized in 2007. This may represent the low point of the recent downward trend.
The primary trend affecting the adequacy of reserve estimates in the core area is the trend in pure loss costs (the combination of frequency and average severity changes) related to malpractice coverage. The inherent pure loss cost trend included in the setting of the 2004, 2005, 2006 and 2007 reserves has been 3.3%, 2.2%, 1.2% and 0.0 % respectively. A change in the pure loss cost trend not only affects the reserving for the current year’s incurred losses, but also previously established reserves, especially IBNR. At 2007 reserve levels, a 1% change in the pure loss costs trend produces a change in prior reserves of approximately $4.0 million. Such changes in estimates are reflected in the period of change. Reserves related to medical malpractice coverage account for 95% of core reserves.
Non-Core Business
The cumulative deficiencies which have emerged for reserves held over the past four years relate entirely to the Company’s non-core healthcare liability and assumed reinsurance reserves which are now in run-off.
Beginning with the Company’s expansion into hospital (1997) and healthcare liability outside of California (1998) and assumed reinsurance (mid 1999), the reserve estimation process became significantly more volatile. The healthcare liability business outside of California did not have the benefits of MICRA-type reform and assumed reinsurance business is, by its nature, extremely volatile.
The Company attempted to apply the same conservative reserving process as had been applied in the core business reserves. Because the Company’s expansion into the hospital and the healthcare liability outside of California represented new areas for which the Company had limited historical experience. As the actual extent and size of the increases in the frequency and severity of claims related to the non-core healthcare liability areas emerged in the actuarial data used to project reserve levels, upward reserve adjustments were necessary. Although the Company took significant rate action and underwriting restrictions were implemented, ultimately the Company withdrew from these markets (hospitals in 2001 and non-core healthcare physician business in 2002.) Development in the non-core healthcare reserves of between 6.6% unfavorable and 2.3% favorable has occurred over the last four years.
Since very few new claims are reported in this area, the primary factor in determining the need for additional reserves is whether current settlement patterns are conforming to the reserving models. In 2007, current patterns indicated no reserve change was required. Since several of the legal jurisdictions outside of California where the Company used to write policies require many years for claims to settle through the system, future events could affect the adequacy of carried reserves. If claims ultimately close for an average of $15,000 more than currently reserved on average, additional reserves of $1.1 million would be required.
The Assumed Reinsurance operations encompassed various risks in the worldwide reinsurance market. The Company has relied heavily on ceding company information in establishing loss reserves, including IBNR. The assumed reinsurance reserves have a very long development pattern and are subject to frequent delays in reporting through the worldwide reinsurance system.
CEDED REINSURANCE PROGRAMS
The Company follows customary industry practice by reinsuring a portion of its healthcare liability insurance risks. The Company cedes to reinsurers a portion of its risks and pays a fee based upon premiums received on all policies subject to such reinsurance. Insurance is ceded principally to reduce net liability on individual risks and to provide protection against large losses. Although reinsurance does not legally discharge the ceding insurer from its primary liability for the full amount of the policies reinsured, it does make the reinsurer liable to the insurer to the extent of the reinsurance ceded. The Company determines how much reinsurance to purchase based upon its evaluation of the risks it has insured, consultations with its reinsurance brokers and market conditions, including the availability and pricing of reinsurance. In 2007, the Company ceded $11.2 million of its healthcare liability earned premiums to reinsurers.
From 2002 through 2007 the Company has reinsured losses above a retention of approximately $2.0 million to $20.0 million subject to an aggregate deductible of $3.0 million in each respective year for losses in excess of the Company’s retention. For 2003 and 2002 the Company also reinsured losses in excess of $20.0 million up to $50.0 million subject to 16% and 8% Company participation in these reinsurance layers, respectively. For 2001 and 2000 the Company reinsured losses above a $1.25 million and $2.0 million retention, respectively, up to $70.0 million subject to a $3.0 million aggregate deductible for each year. Prior to 2000 the Company generally reinsured losses up to $20.0 million above a $1 million retention subject to a $1 million aggregate deductible.
The Company may have more than one insured named as a defendant in a lawsuit or claim arising from the same incident, and, therefore, multiple policies and limits of liability may be involved. The Company’s reinsurance program is purchased in several layers, the limits of which may be reinstated under certain circumstances, at the Company’s option, subject to the payment of additional premiums.
In addition, in December 2002, the Company entered into the Rosemont Re retrocessional reinsurance agreement more fully described in “Note 4 to Consolidated Financial Statements” and “Business Operations in Run-Off-Divestitures of Most Reinsurance Operations-The Rosemont Re Treaty.”
In general, reinsurance is placed under reinsurance treaties and agreements with a number of individual companies and syndicates at Lloyd’s to avoid concentrations of credit risk. The following table identifies the Company’s most significant reinsurers based upon recoverable balances as of December 31, 2007 by company and their current A.M. Best ratings. No other single reinsurer’s percentage participation in 2007 exceeded 7.0% of total reinsurance premiums ceded.
(1)
All ratings are assigned by A.M. Best.
In December 2002, when the Company entered into its 100% quota share arrangement with Rosemont Re, Rosemont Re had an A- rating from A.M. Best. As a result of significant losses related to hurricanes Katrina, Rita and Wilma, Rosemont Re has been placed in run-off.
Assets approximately equal to Rosemont Re’s estimated liabilities under the reinsurance agreement with the Company are currently held in trust to satisfy the liabilities under the agreement. The provisions of the trust are intended to comply with the requirements of the California Department of Insurance. If the estimated recoveries were to increase in the future, the Company would have to rely on Rosemont Re’s continuing ability to fund these amounts. As of June 30, 2007, Rosemont Re reported $66.2 million of shareholder’s equity.
The Company analyzes the credit quality of its reinsurers and relies on its brokers and intermediaries to assist in such analysis. To date, the Company has not experienced any material difficulties in collecting reinsurance recoverables. No assurance can be
given, however, regarding the future ability of any of the Company’s reinsurers to meet their obligations. Should future events cause the Company to determine adjustments in the amounts recoverable from reinsurance are necessary, such adjustments would be reflected in the results of current operations.
INVESTMENT PORTFOLIO
An important component of the Company’s operating results has been the return on its invested assets. The Company’s investments are made by investment managers under policies established and supervised by management, the Boards of Directors for the Company and the Insurance Subsidiaries. The Company’s investment policy has placed primary emphasis on investment grade, fixed-maturity securities and maximization of after-tax yields.
All of the fixed-maturity securities are classified as available-for-sale and carried at estimated fair value. For these securities, temporary unrealized gains and losses, net of tax, are reported directly through stockholders’ equity, and have no effect on net income. The following table sets forth the composition of the Company’s investments in available-for-sale securities at the dates indicated:
The Company’s current policy is to limit its investment in equity securities and real estate to no more than 8.0% of the total market value of its investments. The Company’s investment portfolio of fixed-maturity securities consists primarily of intermediate-term, investment-grade securities. The Company’s investment policy provides that fixed-maturity investments are limited to purchases of investment-grade securities or unrated securities which, in the opinion of a national investment advisor, should qualify for such rating.
As of December 31, 2007, the Company held mortgage and asset-backed securities with a fair value of $64.1 million. Of these securities, 60.3% were backed by U.S. Government or U.S. Government-sponsored enterprise guarantees, 39.4% were asset-backed securities with a remaining .3% in securities collateralized by mortgages that have characteristics of sub-prime lending.
The exposure to sub-prime residential mortgage lending is through a single issue within the Company’s fixed income investment portfolio that contains securities collateralized by mortgages that have characteristics of sub-prime lending. This investment is in the form of a collateral mortgage obligation supported by sub-prime mortgage loans. The collective carrying value of this investment is approximately $.2 million, representing less than 1/10 of 1 percent of the Company’s total fixed income investments, and had a Standard & Poor’s credit rating of AAA. This security was not considered as other than temporarily impaired as of December 31, 2007. While the Company’s exposure to sub-prime securities is not significant to the total investment portfolio, if the residential mortgage market continues to decline and / or the decline expands beyond the U.S. sub-prime, such circumstances could ultimately have an impact on other securities held within the investment portfolio.
The table below contains additional information concerning the investment ratings of the Company’s fixed-maturity investments at December 31, 2007:
(1)
The ratings set forth above are based on the ratings, if any, assigned by Standard & Poor’s Corporation (S&P). If S&P’s ratings were unavailable, the equivalent ratings supplied by Moody’s Investors Services, Inc. were used.
The following table sets forth certain information concerning the maturities of fixed-maturity securities in the Company’s investment portfolio as of December 31, 2007:
The average weighted maturity of the securities in the Company’s fixed-maturity portfolio as of December 31, 2007, was 4.1 years. The average duration of the Company’s fixed-maturity portfolio as of December 31, 2007, was 2.8 years.
The Company maintains cash and highly liquid short-term investments, which at December 31, 2007, totaled $217.3 million. As investments matured or were called in recent periods, the Company grew its short-term investment position as it represented an attractive sector. As market conditions change the Company will look for strategic opportunities to reinvest these short-term investments in fixed-maturity securities in accordance with its guidelines.
The following table summarizes the Company’s investment results for the three years ended December 31, 2007, 2006 and 2005:
(1)
Includes fixed-maturity securities and equities at market and cash equivalents.
In 2001 and 2002 the Company recognized significant capital gains primarily to generate statutory surplus to improve its capital adequacy ratios. In addition, the Company moved its portfolio entirely into taxable securities over the 2002-2003 time frame to maximize its cash income based on its current tax position. As a result, the majority of securities in the Company’s portfolio were purchased after 2002. The Company’s average yield may be less than other comparable insurance companies who have a portfolio of securities which include securities purchased prior to 2002 when interest rates were, in general, higher.
COMPETITION
The California physician professional liability insurance market is highly competitive. The Company competes principally with three physician-owned mutual or reciprocal insurance companies and a physician-owned mutual protection trust for physician and medical group insureds. Two of the companies and the trust solicit insureds in Southern California, the Company’s primary area of operations, and each has offered competitive rates during the past few years. In addition, two of these companies have announced that they will provide some level of dividends to their policyholders during 2007. The Company believes that the principal competitive factors, in addition to pricing, include financial stability, breadth and flexibility of coverage and the quality and level of services provided. In addition, large commercial insurance companies actively compete in this market, particularly for larger medical groups, hospitals and other healthcare facilities. The Company has considered its A.M. Best rating to be extremely important to its ability to compete. The Company currently has a B+ (Good) rating from A.M. Best, while its principal competitors in California have ratings of A- or better. See “A.M. Best Rating” for a description of potential impact of these reductions. See also “Risk Factors-Importance of A.M. Best Rating.”
In Delaware, the Company competes principally through its relationship with a Delaware broker, who has considerable and long-standing relationships with Delaware physician insureds.
REGULATION
General
Insurance companies are regulated by government agencies in each state in which they transact insurance. The extent of regulation varies by state, but the regulation usually includes: (i) regulating premium rates and policy forms; (ii) setting minimum capital and surplus requirements; (iii) regulating guaranty fund assessments; (iv) licensing companies and agents; (v) approving accounting methods and methods of establishing statutory loss and expense reserves; (vi) establishing requirements for and limiting the types and amounts of investments; (vii) establishing requirements for the filing of annual statements and other financial reports; (viii) conducting periodic statutory examinations of the affairs of insurance companies; (ix) approving proposed changes of control; and (x) limiting the amounts of dividends that may be paid without prior regulatory approval. Such regulation and supervision are primarily for the benefit and protection of policyholders and not for the benefit of investors.
Licenses
SCPIE Indemnity, AHI and AHSIC are licensed in their respective states of domicile--California, Delaware and Arkansas. AHI is also licensed to transact insurance and reinsurance in 47 states and the District of Columbia. This permits ceding company clients to take credit on their regulatory financial statements for reinsurance ceded to AHI in jurisdictions in which it is authorized as a reinsurer. AHSIC is licensed to write policies as an excess and surplus lines insurer in 20 states. SCPIE Indemnity is not licensed in any jurisdiction outside of California.
SCPIE Underwriting Limited is authorized under the laws of the United Kingdom to participate as a corporate member of Lloyd’s underwriting syndicates.
Most of the Company’s healthcare liability insurance policies are written in California where SCPIE Indemnity is domiciled. California laws and regulations, including the tort liability laws, and laws relating to professional liability exposures and reports, have the most significant impact on the Company and its operations.
Insurance Guaranty Associations
Most states, including California, require admitted property and casualty insurers to become members of insolvency funds or associations that generally protect policyholders against the insolvency of such insurers. Members of the fund or association
must contribute to the payment of certain claims made against insolvent insurers. Maximum contributions required by law in any one year vary by state, and California permits a maximum assessment of 2% of annual premiums written by a member in that state during the preceding year. However, such payments are recoverable by law through policy surcharges.
Holding Company Regulation
SCPIE Holdings is subject to the California Insurance Holding Company System Regulatory Act (the Holding Company Act). The Holding Company Act requires the Company to periodically file information with the California Department of Insurance and other state regulatory authorities, including information relating to its capital structure, ownership, financial condition and general business operations. Certain transactions between an insurance company and its affiliates of an “extraordinary” type may not be effected if the California Commissioner disapproves the transaction within 30 days after notice. Such transactions include, but are not limited to, certain reinsurance transactions and sales, purchases, exchanges, loans and extensions of credit and investments, in the net aggregate, involving more than the lesser of 3% of the insurer’s admitted assets or 25% of surplus as to policyholders, as of the preceding December 31.
The Holding Company Act also provides that the acquisition or change of “control” of a California insurance company or of any person or entity that controls such an insurance company cannot be consummated without the prior approval of the California Insurance Commissioner. In general, a presumption of “control” arises from the ownership of voting securities and securities that are convertible into voting securities, which in the aggregate constitute more than 10% of the voting securities of a California insurance company or of a person or entity that controls a California insurance company, such as SCPIE Holdings Inc. A person or entity seeking to acquire “control,” directly or indirectly, of the Company is generally required to file with the California Commissioner an application for change of control containing certain information required by statute and published regulations and provide a copy of the application to the Company. The Holding Company Act also effectively restricts the Company from consummating certain reorganizations or mergers without prior regulatory approval.
The Company is also subject to insurance holding company laws in other states that contain similar provisions and restrictions.
Regulation of Dividends from Insurance Subsidiaries
The Holding Company Act also limits the ability of SCPIE Indemnity to pay dividends to the Company. Without prior notice to and approval of the Insurance Commissioner, SCPIE Indemnity may not declare or pay an extraordinary dividend, which is defined as any dividend or distribution of cash or other property whose fair market value together with other dividends or distributions made within the preceding 12 months exceeds the greater of such subsidiary’s statutory net income of the preceding calendar year or 10% of statutory surplus as of the preceding December 31. Applicable regulations further require that an insurer’s statutory surplus following a dividend or other distribution be reasonable in relation to its outstanding liabilities and adequate to meet its financial needs, and permit the payment of dividends only out of statutory earned (unassigned) surplus unless the payment out of other funds is approved by the Insurance Commissioner. In addition, an insurance company is required to give the California Department of Insurance notice of any dividend after declaration, but prior to payment.
The other insurance subsidiaries are subject to similar provisions and restrictions under the insurance holding company laws of the other states in which they are organized.
Risk-Based Capital
The NAIC has developed a methodology for assessing the adequacy of statutory surplus of property and casualty insurers which includes a risk-based capital (RBC) formula that attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potentially under-capitalized companies. Under the formula, a company determines its authorized control level RBC by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). The RBC rules provide for four different levels of regulatory attention depending on the ratio of a company’s total adjusted capital to its authorized control level RBC. The threshold requiring the least regulatory attention is a company action level when total adjusted capital is less than or equal to 200% of the authorized control level RBC and the level requiring the most regulatory involvement is a mandatory control level RBC when total adjusted capital is less than 70% of authorized control level RBC. At the mandatory control level the state Insurance Commissioner is required to restrict the writing of business or place the insurer under regulatory supervision or control.
At December 31, 2007, the adjusted surplus level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2007, SCPIE Indemnity’s adjusted surplus level of $195.8 million was 466% of this threshold.
Regulation of Investments
The Insurance Subsidiaries are subject to state laws and regulations that require diversification of their investment portfolios and limit the amount of investments in certain investment categories such as below investment grade fixed-income securities, real estate and equity investments. Failure to comply with these laws and regulations would cause investments exceeding regulatory limitations to be treated as nonadmitted assets for purposes of measuring statutory surplus and, in some instances, would require divestiture of these non-qualifying investments over specified time periods unless otherwise permitted by the state insurance authority under certain conditions.
Prior Approval of Rates and Policies
Pursuant to the California Insurance Code, the Insurance Subsidiaries must submit rating plans, rates, and certain policies and endorsements to the Commissioner for prior approval. The possibility exists that the Company may be unable to implement desired rates, policies, endorsements, forms or manuals if the Insurance Commissioner does not approve these items. AHI is similarly required to make policy form and rate filings in most of the other states to permit the Company to write medical malpractice insurance in these states. AHSIC is required in many states to obtain approval to issue policies as a non-admitted excess and surplus lines insurer, but it is typically not required to obtain rate approvals.
The Company has encountered challenges to its rate applications in recent years. See “Risk Factors-Rate Increases in California.” The Commissioner approved in its entirety the Company’s most recent application, which was implemented on January 1, 2005. As a result of the performance of its core business during the past two years the Company did not have a rate increase in 2007, and will not have a rate increase in 2008.
Medical Malpractice Tort Reform
The California Medical Injury Compensation Reform Act (MICRA), enacted in 1975, has been one of the most comprehensive medical malpractice tort reform measures in the United States. MICRA currently provides for limitations on damages for pain and suffering of $250,000, limitations on fees for plaintiffs’ attorneys according to a specified formula, periodic payment of medical malpractice judgments and the introduction of evidence of collateral source benefits payable to the injured plaintiff. The Company believes that this legislation has brought stability to the medical malpractice insurance marketplace in California by making it more feasible for insurers to assess the risks involved in underwriting this line of business. Bills have been introduced in the California Legislature from time to time to modify or limit certain of the tort reform benefits provided to physicians and other healthcare providers by MICRA. Neither the proponents nor opponents have been able to enact significant changes. The Company cannot predict what changes, if any, to MICRA may be enacted during the next few years or what effect such changes might have on the Company’s medical malpractice insurance operations.
Medical Malpractice Reports
The Company has been required to report detailed information with regard to settlements or judgments against its California physician insureds in excess of $30,000 to the Medical Board of California, which has responsibility for investigations and initiation of proceedings relating to professional medical conduct in California. Since January 1, 1998, all judgments, regardless of amount, must be reported to the Medical Board, which now publishes on the Internet all judgments reported and in the future will publicize certain settlements above $30,000. In addition, all payments must also be reported to the federal National Practitioner Data Bank and such reports are accessible by state licensing and disciplinary authorities, hospital and other peer review committees and other providers of medical care. A California statute also requires that defendant physicians must consent to all medical professional liability settlements in excess of $30,000, unless the physician waives this requirement. The Company’s policy provides the physician with the right to consent to any such settlement, regardless of the amount, but that either party may submit the matter of consent to a medical review board. In virtually all instances, the Company must obtain the consent of the insured physician prior to any settlement.
Health Insurance Portability and Accountability Act
The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) was enacted by Congress to ultimately simplify the healthcare administrative process. HIPAA contains a variety of provisions, including privacy and security rules designed to
maintain the confidentiality, integrity and availability of “protected health information.” Protected health information includes, among other things, medical and billing records relating to medical care provided by the Company’s insureds and loss descriptions and other information relating to medical liability claims asserted by patients against such insureds. The Company has developed various documents and procedures for use with its insureds and vendors to safeguard this information from disclosure and use not permitted under HIPAA.
A.M. BEST RATING
A.M. Best rates insurance companies based on factors of concern to policyholders. A.M. Best currently assigns to each insurance company a rating that ranges from “A++ (Superior)” to “F (In Liquidation).” A.M. Best reviews a company’s profitability, leverage and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. A.M. Best’s ratings reflect its opinion of an insurance company’s financial strength, operating performance and ability to meet its obligations to policyholders and are not evaluations directed to purchasers of an insurance company’s securities.
For a number of years, the Insurance Subsidiaries received an A.M. Best rating of A (Excellent), the third highest rating classification. As a result of losses in the non-core businesses, the Company’s rating was reduced in 2002 and 2003 to B (Fair). The Company took actions to improve its capital adequacy position through the orderly withdrawal from the non-core healthcare and assumed reinsurance businesses. In November, 2006, A.M. Best increased its rating for the Insurance Subsidiaries to B+ (Good). With the recent announcement that SCPIE Holdings Inc. has entered into a definitive agreement to be acquired by The Doctors Company, A. M. Best has placed the Company under review with developing implications. A.M. Best assigns a B+ rating to companies that have, in its opinion, a good ability to meet their ongoing obligations to policyholders.
An A.M. Best rating of at least an A- classification is important to some consumers in the property/casualty insurance industry. At the present time, the Company has not been significantly affected by the lower A.M. Best ratings. The Company believes that its major competitors in California may use the Insurance Subsidiaries’ lower A.M. Best rating in an attempt to solicit some of the Company’s customers.
The Insurance Subsidiaries participate in a pooling arrangement and each of the Insurance Subsidiaries has been assigned the same “pooled” “B+ (Good)” A.M. Best rating based on their consolidated performance.
EMPLOYEES
As of December 31, 2007, the Company employed 107 persons. None of the employees are covered by a collective bargaining agreement. The Company believes that its employee relations are good.
EXECUTIVE OFFICERS
The Executive Officers of the Company and their ages as of March 6, 2008, are as follows:
Donald J. Zuk became Chief Executive Officer of the Company’s predecessor in 1989. Prior to joining the Company, he served 22 years with Johnson & Higgins, insurance brokers. His last position there was Senior Vice President in charge of its Los Angeles Health Care operations, which included the operations of the Company’s predecessor. Mr. Zuk is a director of BCSI Holdings Inc., a privately held insurance company.
Ronald L. Goldberg joined the Company in May 2001. From June 2000 to April 2001, Mr. Goldberg was a Senior Consultant to ChannelPoint, Inc., a privately held firm providing technology services to the insurance industry. Prior to that time, Mr. Goldberg served as Senior Vice President of the PHICO Group, a privately held professional liability insurer, from June 1998 to May 2000, and as President of its Independence Indemnity Insurance Company subsidiary. From April 1993 to May 1998, he was Vice President of USF&G Insurance Co., a large diversified insurance company that is now part of The St. Paul Travelers Companies, Inc.
Joseph P. Henkes has been with the Company since 1990, serving initially as Vice President, Operations and Actuarial Services. He was named Senior Vice President, Operations and Actuarial Services in 1992. Prior to joining the Company, he served three years with Johnson & Higgins, insurance brokers, where his services were devoted primarily to the Company. He has been an Associate of the Casualty Actuarial Society since 1975 and a member of the American Academy of Actuaries since 1980.
Robert B. Tschudy joined the Company in May 2002. From July 1995 to March 2001, Mr. Tschudy was Senior Vice President and Chief Financial Officer with 21st Century Insurance Group, a publicly held property casualty insurance company writing primarily personal automobile insurance in California. Prior to that time, Mr. Tschudy was a partner, specializing in insurance, in the Los Angeles Office of Ernst & Young LLP for over 10 years.
Edward G. Marley joined the Company in December 2001 as Vice President and Controller. He was named Chief Accounting Officer in 2003. Prior to that time, he spent 14 years with CAMICO Mutual Insurance Company where he served as Chief Financial Officer, Secretary and Treasurer.
Margaret A. McComb has been with the Company since 1990. Prior to joining the Company, she served 14 years with Johnson & Higgins, insurance brokers. She assumed management responsibility for the Claims Department in 1985. Ms. McComb was named Senior Vice President in May 2002.
ITEM 1A.
ITEM 1A. RISK FACTORS
The Company’s business involves various risks and uncertainties, some of which are discussed in this section. The information discussed below should be considered carefully with the other information contained in this Annual Report on Form 10-K and the other documents and materials filed by the Company with the SEC, as well as news releases and other information publicly disseminated by the Company from time to time.
The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties not presently known to the Company, or that it currently believes to be immaterial, may also adversely affect the Company’s business. Any of the following risks or uncertainties that develop into actual events could have a materially adverse effect on the Company’s business, financial conditions or results of operations.
Proposed Merger with The Doctors Company
On October 15, 2007, the Company agreed to be acquired by The Doctors Company for $28.00 in cash for each outstanding share of Company common stock in a merger transaction valued at approximately $281.1 million. The merger is subject to customary closing conditions, including, among others, (i) the approval of the merger by the holders of a majority in voting power of the outstanding common stock of the Company; (ii) the approval of the merger by the Departments of Insurance of California, Delaware and Arkansas; (iii) the receipt of antitrust approvals, or the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; and (iv) the absence of any order or injunction prohibiting the consummation of the merger. The Company currently expects the merger to close during the first half of 2008. However, it is possible that factors outside of the Company’s control could require the parties to complete the proposed merger at a later time or not to complete it at all.
In addition, the announcement of the proposed merger may have a negative impact on the Company due to:
•
risks that the proposed merger disrupts current plans and operations and potential difficulties in employee retention as a result of the merger;
•
the effect of the announcement of the merger on the Company’s agent, broker and customer relationships, operating results and business generally; and
•
the amount of the costs, fees, expenses and charges related to the merger.
In the event that the proposed merger is not completed:
•
under specified circumstances, the Company may be required to pay a termination fee of up to 3% of the aggregate merger consideration; and
•
the market price of the Company’s common stock may decline to the extent that the current market price reflects a market assumption that the proposed merger will be completed.
Any of these events could have a negative impact on the Company’s results of operations and financial condition and could adversely affect the price of its common stock.
Concentration of Business
Substantially all of the Company’s direct premiums written are generated from healthcare liability insurance policies issued to physicians and medical groups, healthcare facilities and other providers in the healthcare industry. As a result, negative developments in the economic, competitive or regulatory conditions affecting the healthcare liability insurance industry, particularly as such developments might affect medical malpractice insurance for physicians and medical groups, could have a material adverse effect on the Company’s results of operations.
Almost all of the Company’s 2008 premiums written will be generated in California. The revenues and profitability of the Company are therefore subject to prevailing regulatory, economic and other conditions in California, particularly Southern California. In addition, approximately 23.3% of premiums written were generated by groups of nine physicians or more. The largest group of physicians accounted for 2.5% of total premiums written in 2007 and one program of affiliated groups, accounted for 6.8% of premiums written in 2007.
Importance of Brokers
In the past few years, brokers have become increasingly important to the Company’s growth. During 2007, the Company wrote approximately 32% of its core healthcare liability business through independent brokers. The Company competes with other insurers for this brokerage business. To maintain its relationship with independent brokers, the Company must pay competitive commissions, be able to respond to their needs quickly and adequately, and create a consistently high level of policyholder service and satisfaction. In addition, an insurer’s A.M. Best rating is an important factor. If a broker finds it preferable to do business with a competitor with a higher A.M. Best rating, it could be difficult to renew existing business written through such broker or attract new business.
Uncertainties of Future Expansion
From 1996 to 2001, the Company significantly expanded its healthcare liability insurance products into markets outside California. This expansion was not successful, and the Company is now “running off” this non-core healthcare liability business. At the present time, the Company has one continuing non-California program for physicians and medical groups in Delaware and may consider adding programs on a selective basis in the future. The Company cannot predict whether this remaining program will be ultimately successful or whether the Company will have the opportunity to add such programs in other jurisdictions, and, if so, whether any additional program will be successful. Success will depend upon, among other things, the A.M. Best rating of the insurance subsidiaries and the Company’s access to sufficient capital for any future expansion and its ability to accurately underwrite the healthcare risks and adequately price its policies in these other jurisdictions in which the Company does not have current experience.
Industry Factors
Many factors influence the financial results of the healthcare liability insurance industry, several of which are beyond the control of the Company. These factors include, among other things, changes in severity and frequency of claims; changes in applicable law and regulatory reform; changes in judicial attitudes toward liability claims; and changes in inflation, interest rates and general economic conditions.
The availability of healthcare liability insurance, or the industry’s underwriting capacity, is determined principally by the industry’s level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy. Historically, the financial performance of the healthcare liability insurance industry has tended to fluctuate between a soft insurance market and a hard insurance market. In a soft insurance market, competitive conditions could result in premium rates
and underwriting terms and conditions that may be below profitable levels. For a number of years, the healthcare liability insurance industry in California and nationally has faced a soft insurance market. Although the Company believes that the California insurance market is profitable, there can be no assurance that this profitability will continue or as to its effect on the Company’s financial condition and results of operations.
Competition
The Company competes with numerous insurance companies in the California market. The Company’s principal competitors for physicians and medical groups in California consist of three physician-owned mutual or reciprocal insurance companies, several commercial companies and a physicians’ mutual protection trust, which levies assessments primarily on a “claims paid” basis. In addition, commercial insurance companies compete for the medical malpractice insurance business of larger medical groups and other healthcare providers. Several of these competitors have greater financial resources than the Company. Between 1993 and 2002, the Company instituted overall rate increases in order to improve its underwriting results. These rate increases were higher than those implemented by most of its competitors. As a result, the Company lost some of its policyholders, in part due to its rate increases. In 2003, the Company’s rates became more competitive, as its requested rate increase for that year was delayed until the fourth quarter. In October 2003, the Company instituted an average 9.9% rate increase for California physicians and medical groups and in January 2005, implemented an additional 6.5% rate increase. The Company believes its rates remain generally competitive with those of other companies, after giving effect to these rate increases. The effect of any future rate increases on the Company’s ability to retain and expand its healthcare liability insurance business in California is uncertain.
In addition to pricing, competitive factors may include policyholder dividends, financial stability, breadth and flexibility of coverage and the quality and level of services provided. Three of the Company’s physician-owned competitors have announced their intention to pay some level of policyholder dividends in California in 2008.
The Company considers its A.M. Best rating to be extremely important to its ability to compete in its core markets. The Company’s current rating of B+ (Good) could adversely affect the Company’s ability to attract and retain policyholders in California and Delaware. See “Importance of A.M. Best Rating.”
Loss and LAE Reserves
The reserves for losses and LAE established by the Company are estimates of amounts needed to pay reported and unreported claims and related LAE. The estimates are based on assumptions related to the ultimate cost of settling such claims based on facts and interpretation of circumstances then known, predictions of future events, estimates of future trends in claims frequency and severity, judicial theories of liability, legislative activity, reports from ceding reinsurers and other factors. However, establishment of appropriate reserves is an inherently uncertain process involving estimates of future losses, and there can be no assurance that currently established reserves will prove adequate in light of subsequent actual experience.
The inherent uncertainty is greater for healthcare liability reserves where a longer period may elapse before a definite determination of ultimate claim liability is made, and where the judicial, political and regulatory climates are changing. Healthcare liability claims and expenses may be paid over a period of 10 or more years, which is longer than most property and casualty claims. Trends in losses on long-tail lines of business such as healthcare liability may be slow to appear, and accordingly, the Company’s reaction in terms of modifying underwriting practices and changing premium rates may lag underlying loss trends. The core healthcare liability net reserves account for $283.3 million or 81.4% of total net reserves as of December 31, 2007. This portion of the reserves has the most historical experience available for actuarial analysis, and therefore should be the most predictable. A change of 1% in estimated loss cost trends based on more recent experience would have an effect of approximately $7.4 million on estimated reserve levels.
The reserves related to the non-core healthcare liability business present additional problems in determining adequate reserves. As the size of these reserves decline and the number of underlying cases decrease, the ultimate losses become more related to specific case results. Therefore, unexpected legal results in healthcare liability cases can produce unexpected reserve development. This was evident in 2004 as one adverse verdict in a Florida hospital case and an unexpected rise in severe dental claims caused a material upward development of prior years reserves. Since some of the remaining cases in the non-core
healthcare liability business will ultimately go to trial many years after the event of loss, adverse verdicts or settlements at trial may affect the accuracy of future reserving. As of December 31, 2007, non-core healthcare liability reserves accounted for $23.9 million or 6.9% of total net reserves. Outstanding claims are 75 at December 31, 2007.
The following table presents the net assumed reinsurance reserves (including retrospective reserves ceded under the Rosemont Re Treaty of $5.7 million, $6.4 million, and $7.1 million, respectively) by major component as of December 31:
(1)
Additional net liabilities of $3.6 million representing payment requests made to the Company are included in other liabilities on the Company’s balance sheet. These net liabilities are being contested in pending arbitrations. (See “Legal Proceedings-Bail and Immigration Bond Proceedings.”)
Approximately 60% of the net assumed reinsurance reserves outstanding as of December 31, 2007 are supported by actuarial work performed by or for the ceding insurers. Since the time required for the ultimate losses to be reported through the worldwide reinsurance system may cover several years, unexpected events are more difficult to predict.
Establishing reserves in the assumed reinsurance area is complicated by the delay in reporting that naturally occurs as information passes through the worldwide reinsurance network. In addition, sudden and catastrophic events do occur and further complicate the reserving process. Such events have caused the Company to revise upward its assumed reinsurance reserves over time. Examples of these types of events include the World Trade Center terrorist attack in 2001, the sudden collapse of GoshawK Syndicate 102 in 2003 and the collapse of a large bonding company in 2004. (See Legal Proceedings-Bail and Immigration Bond Proceedings). In 2005 and 2007 a number of London-based insureds including various Lloyd’s syndicates increased reserve estimates from 2000 and 2001 policy years. The Company believes that its current assumed reinsurance reserve levels are adequate, but they may vary as the Company receives new information from the ceding insurers.
While the Company believes that its reserves for losses and LAE are adequate, there can be no assurance that the Company’s ultimate losses and LAE will not deviate, perhaps substantially, from the estimates reflected in the Company’s financial statements. If the Company’s reserves should prove inadequate, the Company will be required to increase reserves, which could have a material adverse effect on the Company’s financial condition or results of operations.
Rate Changes in California
California law requires that the Insurance Subsidiaries must submit proposed rate changes in California to the California Commissioner for approval prior to implementation. Interested parties have the right to object to such proposed changes, and to request hearings that can be time consuming, if granted, and can result in rulings adverse to the applicant. A consumer group has challenged proposed rate increases by the Company in recent years, with some success. The Commissioner approved in its entirety the Company’s most recent application, which was implemented on January 1, 2005.
The Company plans to file applications for future rate changes in California that it considers justified by reason of its loss experience. The Company may encounter objections and delays in obtaining approval of any requested changes. If future rate requests are denied or significantly reduced, or if there are substantial delays in implementing a favorable decision, the Company’s operations could be adversely affected.
Necessary Capital and Surplus
Measures of capital and surplus are used in the casualty insurance industry to evaluate the safety and financial strength of an insurer. Recognized guidelines in the Company’s segment are that (i) an insurer should not operate at a ratio of net premiums written to statutory capital and surplus (policyholder surplus) greater than 1 to 1, and (ii) an insurer should not have a ratio of
net loss and LAE reserves to policyholder surplus greater than 3 to 1. In recent years the Company had unfavorably exceeded both these measures because of the losses incurred in the non-core healthcare liability insurance and assumed reinsurance business. During 2005, 2006 and 2007, the Company has improved its capital and surplus position. At December 31, 2007, the Company had a ratio of net premiums written to policyholder surplus of .61 to 1 and a ratio of net loss and LAE reserves to policyholder surplus of 1.78 to 1. The Company cannot predict whether this improvement in policyholder surplus will be sufficient to result in continued improved ratings from A.M. Best.
The Company may need to raise additional statutory capital through financings to improve its financial rating. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company. In the case of equity financings, dilution to the Company’s stockholders could result, and in any case securities may have rights preferences and privileges that are senior to those of the Company’s current stockholders. Debt financing would impact future earnings because of interest charges.
Liquidity
The Company’s investment portfolio primarily consists of readily marketable fixed-income securities. In addition, the Company holds a significant cash and short-term investment position as of December 31, 2007. Should cash needs of the Company, primarily loss reserve payments, require the unplanned sale of a portion of the fixed income portfolio when the portfolios carrying value is in excess of current market rates, losses on security sales could impact the Company’s earnings in the period of sale.
Changes in Healthcare
Significant attention has recently been focused on reforming the healthcare system at both the federal and state levels. A broad range of healthcare reform and patients’ rights measures have been suggested, and public discussion of such measures will likely continue in the future. Proposals have included, among others, spending limits, price controls, limits on increases in insurance premiums, limits on the liability of doctors and hospitals for tort claims, increased tort liabilities for managed care organizations and changes in the healthcare insurance system. The Company cannot predict which, if any, reform proposals will be adopted, when they may be adopted or what impact they may have on the Company. While some of these proposals could be beneficial to the Company, the adoption of others could have a material adverse effect on the Company’s financial condition or results of operations.
In addition to regulatory and legislative efforts, there have been significant market-driven changes in the healthcare environment. In recent years, a number of factors related to the emergence of “managed care” have negatively impacted or threatened to impact the medical practice and economic independence of physicians. Physicians have found it more difficult to conduct a traditional fee for service practice and many have been driven to join or contractually affiliate with managed care organizations, healthcare delivery systems or practice management organizations. This consolidation could result in the elimination or significant decrease in the role of the physician and the medical group from the medical professional liability purchasing decision. In addition, the consolidation could reduce primary medical malpractice insurance premiums paid by healthcare systems, as larger healthcare systems generally retain more risk by accepting higher deductibles and self-insured retentions or form their own captive insurance companies.
Importance of A.M. Best Rating
A.M. Best ratings are an increasingly important factor in establishing the competitive position of insurance companies. The rating reflects A.M. Best’s opinion of an insurance company’s financial strength, operating performance and ability to meet its obligations to policyholders. The Company’s principal competitors in the healthcare liability insurance market in California all have an A- or better rating from A.M. Best.
In October 2007, following the Company’s announcement to be acquired by The Doctors Company, A.M. Best Co. placed the financial strength rating (FSR) of B+ (Good) under review with developing implications. In the year prior to the announcement, A.M. Best’s outlook for the Company was stable. The Insurance Subsidiaries ratings are at a competitive disadvantage with its principal California competitors. The Insurance Subsidiaries rely heavily on their longstanding policyholder relations and reputation in California, and compete principally on this basis in the California market. The Insurance Subsidiaries have not currently experienced a significant loss of business because of this A.M. Best rating; however, competitors could use their rating advantage to attract some of the Insurance Subsidiaries’ policyholders. If the Insurance Subsidiaries’ A.M. Best rating were to be reduced, this could have a material adverse effect on the Insurance Subsidiaries’ ability to continue to write policies in some segments of the market.
Ceded Reinsurance
The amount and cost of reinsurance available to companies specializing in medical professional liability insurance are subject, in large part, to prevailing market conditions beyond the control of the Company. The Company’s ability to provide professional liability insurance at competitive premium rates and coverage limits on a continuing basis will depend in part upon its ability to secure adequate reinsurance in amounts and at rates that are commercially reasonable. In general, the Company’s reinsurance agreements are for a one-year term. Although the Company anticipates that it will continue to be able to obtain such reinsurance on reasonable terms, there can be no assurance that this will be the case. In some years, the Company experiences large paid losses under its healthcare liability insurance policies that are in excess of the limits of insurance retained by the Company and thus are borne by the reinsurers.
The Company is subject to a credit risk with respect to its reinsurers because reinsurance does not relieve the Company of liability to its insureds for the risks ceded to reinsurers. Although the Company places its reinsurance with reinsurers it believes to be financially stable, a significant reinsurer’s inability to make payment under the terms of a reinsurance treaty could have a material adverse effect on the Company. Rosemont Re, with which the Company had the largest receivable balance at December 31, 2007, incurred substantial unexpected losses during 2005 as a result of hurricanes Katrina, Rita and Wilma. Rosemont Re has ceased writing any new business and is in run-off. Under the Company’s reinsurance arrangement with Rosemont Re, Rosemont Re assets approximately equal to the estimated liabilities are currently held in trust to satisfy the liabilities. If the liabilities increased materially in the future, the Company would have to look to Rosemont’s Re’s general assets to satisfy any liabilities not covered by the trust assets. As of June 30, 2007, Rosemont Re reported shareholder equity of $66.2 million. See “Business-Ceded Reinsurance Programs.”
Highlands Insurance Group Contingent Liability
The Company is obligated to assume certain policy obligations of Highlands Insurance Company (Highlands) in the event Highlands is declared insolvent by a court of competent jurisdiction and is unable to pay these obligations. The coverages principally involve workers’ compensation, commercial automobile and general liability. Highlands currently is under the jurisdiction of the Texas District Court which appointed the Texas Insurance Commissioner as a permanent Receiver of Highlands in November 2003. The Receiver, through a Special Deputy Receiver (“SDR”) continues to resolve Highlands claim liabilities and otherwise conduct its business as part of his efforts to rehabilitate Highlands. At December 31, 2007, Highlands had established case loss reserves of $2.8 million, net of reinsurance, for the subject policies. Based on a limited review of the exposures remaining, the Company estimates that incurred but not reported (“IBNR”) losses are $2.4 million, for a total loss and loss adjustment expenses (“LAE”) reserve of $5.2 million. This estimate is not based on a full reserve analysis of the exposures and is not recorded in the Company’s reserves. If Highlands is declared insolvent and liquidated by court order, the Company would likely be required to assume Highlands’ remaining obligations under the subject policies.
The receiver has filed a rehabilitation plan with the Texas Court. A hearing on that plan is scheduled for May 12, 2008. In the interim, Highlands continues to pay and settle claims as the Receivership remains in place. If a Rehabilitation Plan ultimately is not approved, Highlands could be placed in liquidation.
Bail and Immigration Bond Proceedings
The Company’s Insurance Subsidiary, AHI, was a reinsurer during 2001 and 2002 under separate reinsurance agreements with Highlands and two other primary insurers covering bail and immigration bond programs administered by a single bonding company. During 2004, the bonding company failed and the primary insurers have made claims against AHI that are now part of active arbitration proceedings. The Company believes that its liability could amount to a potential loss of approximately $6.0 million. The Company’s best estimate of $3.6 million is recorded in the financial statements as part of loss and LAE reserves. See “Legal Proceedings-Bail and Immigration Bond Proceedings.”
Holding Company Structure-Limitation on Dividends
SCPIE Holdings is an insurance holding company whose assets consist of all of the outstanding capital stock of SCPIE Indemnity, which in turn owns all of the outstanding capital stock of AHI and AHSIC. As an insurance holding company, SCPIE Holdings’ ability to meet its obligations and to pay dividends, if any, may depend upon the receipt of sufficient funds from SCPIE Indemnity. The payment of dividends to SCPIE Holdings by SCPIE Indemnity is subject to general limitations imposed by California insurance laws. See “Business-Regulation-Regulation of Dividends from Insurance Subsidiaries” and “Note 6 to Consolidated Financial Statements.”
Anti-Takeover Provisions
SCPIE Holdings’ amended and restated certificate of incorporation and amended and restated bylaws include provisions that may delay, defer or prevent a takeover attempt that stockholders may consider to be in their best interests. These provisions include:
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a classified Board of Directors;
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authorization to issue up to 5,000,000 shares of preferred stock, par value $1.00 per share, in one or more series with such rights, obligations, powers and preferences as the Board of Directors may provide;
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a limitation which permits only the Board of Directors, the Chairman of the Board or the President of SCPIE Holdings to call a special meeting of stockholders;
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a prohibition against stockholders acting by written consent;
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provisions prohibiting directors from being removed without cause and only by the affirmative vote of holders of two-thirds of the outstanding shares of voting securities;
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provisions allowing the Board of Directors to increase the size of the Board and to fill vacancies and newly created directorships;
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provisions that do not permit cumulative voting in the election of directors; and
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advance notice procedures for nominating candidates for election to the Board of Directors and for proposing business before a meeting of stockholders.
The Company is subject to Section 203 of the Delaware general corporation law which, in general, prohibits a publicly held Delaware corporation from engaging in a business combination with an “interested stockholder” for a period of three years following the date the person became an interested stockholder, unless the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner. An “interested stockholder” is defined generally as a person who, together with affiliates and associates, owns or within three years prior to the determination of interested stockholder status, did own, 15% or more of a corporation’s voting stock. The existence of this provision may have an anti-takeover effect with respect to transactions not approved in advance by the Board of Directors.
In addition, state insurance holding company laws applicable to the Company in general provide that no person may acquire control of SCPIE Holdings without the prior approval of appropriate insurance regulatory authorities. See “Business-Regulation-Holding Company Regulation.”
Fluctuations in Stock Price
The market price of the Company’s common stock price could be subject to significant fluctuations and/or may decline. Among the factors that could affect the Company’s stock price are:
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variations in the Company’s operating results;
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actions or announcements by our competitors;
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actions by institutional and other stockholders
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general market conditions; and
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domestic and international economic factors unrelated to our performance.
The stock markets in general have recently experienced volatility that has sometimes been unrelated to the operating performance of particular companies. These broad market fluctuations may cause the trading price of the Company’s common stock to decline.
Regulatory and Related Matters
Insurance companies are subject to supervision and regulation by the state insurance authority in each state in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company’s business and financial condition, including limitations on lines of business, underwriting limitations, the setting of premium rates, the establishment of
standards of solvency, statutory surplus requirements, the licensing of insurers and agents, concentration of investments, levels of reserves, the payment of dividends, transactions with affiliates, changes of control, the approval of policy forms, and periodic examinations of the insurance company’s financial statements and records. Such regulation is concerned primarily with the protection of policyholders’ interests rather than stockholders’ interests. See “Business-Regulation.”
The Risk-Based Capital rules provide for different levels of regulatory attention depending on the amount of a company’s total adjusted capital compared to its various RBC levels. At December 31, 2007 each of the Insurance Subsidiaries’ RBC exceeded the threshold requiring the least regulatory attention. At December 31, 2007, SCPIE Indemnity’s adjusted surplus level of $195.8 million was 466% of this threshold.
State regulatory oversight and various proposals at the federal level may in the future adversely affect the Company’s results of operations. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and certain state legislatures have considered or enacted laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. Further, the NAIC and state insurance regulators are reexamining existing laws and regulations, which in many states has resulted in the adoption of certain laws that specifically focus on insurance company investments, issues relating to the solvency of insurance companies, RBC guidelines, interpretations of existing laws, the development of new laws and the definition of extraordinary dividends. See “Business-Regulation.”
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
In July 1998, the Company entered into a lease covering approximately 95,000 square feet of office space for its Company headquarters. The lease is for a term of 10 years ending in early 2009 and the Company has options to renew the lease for an additional 10 years. The Company moved its headquarters and principal operations to these offices in March 1999. The Company also leases office space for its claims offices in Reston, Virginia, and San Diego, California.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
General
The Company is named as a defendant in various legal actions primarily arising from claims made under insurance policies and contracts. These actions are considered by the Company in estimating the loss and loss adjustment expense reserves. The Company’s management believes that the resolution of these actions will not have a material adverse effect on the Company’s financial position or results of operations.
Bail and Immigration Bond Proceedings
The Company’s Insurance Subsidiary, AHI, was a party to reinsurance agreements with Highlands Insurance Company, now in Receivership (Highlands), Sirius America Insurance Company (Sirius) and Aegis Security Insurance Company (Aegis), each of which acted as a primary insurer for various periods under bail and immigration bond programs administered and guaranteed by Capital Bonding Corporation (CBC), as managing general agent. As part of these programs, the primary insurers (through CBC) issued bail bonds in a number of states and also issued federal immigration bonds. AHI participated as a reinsurer of these programs during 2001 and 2002. The Company’s reinsurance participation was 20% of the bond losses during 2001 and 25% during 2002. The Company’s share of the losses under these treaties was substantially reinsured with Rosemont Re during 2002 and to a lesser extent during 2001.
During 2004, CBC failed and a large number of bond losses emerged for 2000 and subsequent years. There were a number of disputes between the primary insurers and reinsurers in the CBC program. AHI was and is engaged in arbitration proceedings with each of the primary insurers to resolve these disputes. The Sirius, Highlands and Aegis proceedings were instituted on June 13, 2005, August 31, 2005 and December 7, 2005, respectively. The Company’s arbitration proceeding with Aegis concluded on February 10, 2006. The Company paid to Aegis a total amount slightly in excess of the amount reserved for this agreement at December 31, 2005, and the Company has commuted any future LAE and bail bond losses with Aegis. The arbitration hearing with Sirius started on March 5, 2007, and concluded on April 12, 2007. On April 16, 2007, the Sirius Arbitration Panel rendered a final award, requiring AHI to pay its proportionate share of all past and future losses and expenses billed by Sirius to AHI. AHI promptly complied with the award. The Highlands arbitration proceeding is still in its early stages.
The Company believes that its liability under the reinsurance agreements could amount to a potential loss of approximately $6.0 million. The Company has recorded in the financial statements its best reserve estimate of $3.6 million to cover the ultimate net liability under the Sirius and Highlands reinsurance agreements. Highlands has provided claim information to the Company with respect to alleged losses during 2001 and 2002 under bail bonds issued in the State of New Jersey and alleged losses during 2001 under federal immigration bonds. Highlands has indicated in filings that it has additional exposure under bail bonds issued in states other than New Jersey. The Company understands that New Jersey bail bonds and federal immigration bonds represent the vast majority of the bonds issued by Highlands through CBC; however, the Company expects that Highlands will assert similar claims against the reinsurers relating to bail bonds issued in other state jurisdictions. Highlands has not provided sufficient information to measurably quantify certain of these additional losses or allocate such losses among the 2001 and 2002 years in which AHI participated and the 2000 year in which the Company did not participate. Given the uncertainties of these actual and prospective bail bond and other claims, future loss development on the CBC program could be greater than the reserves estimated by the Company at December 31, 2007. The Company intends to vigorously contest the claims of Highlands.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2007.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Price Range of Common Stock
The Company’s Common Stock is publicly traded on the New York Stock Exchange under the symbol “SKP.” The following table shows the closing price ranges per share in each quarter, during the last two years:
On March 10, 2008, the closing price of the Company’s common stock was $27.35.
Stockholders of Record
The number of stockholders of record of the Company’s Common Stock as of March 10, 2008, was 4,724.
Dividends
SCPIE Holdings paid quarterly cash dividends on its common stock from 1997 to 2003. In March 2004, the Board of Directors suspended its quarterly dividends. Future payment and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions.
As a holding company, SCPIE Holdings is largely dependent upon dividends from its subsidiaries to pay dividends to its stockholders. These subsidiaries are subject to state laws that restrict their ability to distribute dividends. State law permits payment of dividends and advances within any 12-month period without any prior regulatory approval in an amount up to the greater of 10% of statutory earned surplus at the preceding December 31 or statutory net income for the calendar year preceding the date the dividend is paid. Under these restrictions, neither AHI nor AHSIC may pay a dividend during 2008 to SCPIE Indemnity without regulatory approval. SCPIE Indemnity paid $3.0 million in 2006 and no dividend in 2007 to SCPIE Holdings. SCPIE Indemnity is entitled to pay dividends in 2008 of up to $31.9 million to SCPIE Holdings. See “Business-Regulation-Regulation of Dividends from Insurance Subsidiaries” and “Note 6 to Consolidated Financial Statements.”
The graph below compares the cumulative total stockholder return on the shares of Common Stock of the Company for the period from December 31, 2002 through December 31, 2007, with the cumulative total return on the Standard and Poor’s 500 Index (the “S&P 500 Index”) and the SNL All Property & Casualty Insurance Index (the SNL Index”) over the same period (assuming the investment of $100 in the Company’s Common Stock on December 31, 2002 and the reinvestment of all dividends.)
Total Return Performance
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
(1)
Premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Premium written is a statutory measure of production levels. Premiums earned, the most directly comparable GAAP measure, represents the portion of premiums written that is earned, on a pro-rata basis, as income in the financial statements for the periods presented. The change in unearned premium reconciles the difference between the two measures.
(2)
Basic earnings (loss) per share of common stock at December 31, 2007, 2006, 2005, 2004, and 2003 are computed using the weighted average number of common shares outstanding during the year of 9,569,859, 9,524,570, 9,455,391, 9,387,556, and 9,352,070, respectively. Diluted earnings per share of common stock at December 31, 2007, 2005, 2004, 2003 and 2002 are computed using the weighted average number of common shares outstanding during the year of 9,866,187, 9,657,059, 9,549,353, 9,387,556, and 9,352,070 respectively. For further discussion of basic earnings per share and diluted earnings per share, see “Note 10 to Consolidated Financial Statements.”
ITEM 7.
ITEM 7. 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 the related notes thereto appearing elsewhere in this Form 10-K. The consolidated financial statements include the accounts and operations of SCPIE Holdings Inc. and subsidiaries.
Certain statements in this annual report on Form 10-K that are not historical in fact constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA provides certain “safe harbor” provisions for forward-looking statements. All forward-looking statements made in this annual report on Form 10-K are made pursuant to the PSLRA. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” and similar expressions are intended to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors based on the Company’s estimates and expectations concerning future events that may cause the actual results of the Company to be materially different from historical results or from any results expressed or implied by such forward-looking statements. These risks and uncertainties, as well as the Company’s critical accounting policies, are discussed in more detail under “Business-Risk Factors” and “Management’s Discussion and Analysis-Critical Accounting Policies” and in periodic filings with the Securities and Exchange Commission. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.
OVERVIEW
SCPIE Holdings is a holding company owning subsidiaries engaged in providing insurance and reinsurance products. The Company is primarily a provider of medical malpractice insurance and related liability insurance products to physicians, healthcare facilities and others engaged in the healthcare industry in California and Delaware. Previously, the Company had also been actively engaged in the medical malpractice insurance business and related products in other states and in the assumed reinsurance business.
The Company’s insurance business is organized into two reportable business segments: direct healthcare liability insurance and assumed reinsurance operations. Since 2002, the Company has focused on its core healthcare liability business.
During 2002 and 2003, the Company largely completed its withdrawal from the assumed reinsurance market and medical malpractice insurance outside of California and Delaware. The actions taken by the Company to exit the liability business other than California and Delaware and the quota share reinsurance agreement with Rosemont Re, have significantly reduced capital requirements related to the net premium written to surplus ratio in both the A.M. Best and NAIC capital adequacy models. The capital requirements associated with the reserve to surplus ratio continue to decline as the Company settles the claims in its non-core businesses.
CRITICAL ACCOUNTING POLICIES
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). Preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related notes. Management believes that the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. Actual results may differ from these estimates under different assumptions or conditions.
Premium Revenue Recognition
Direct healthcare liability insurance premiums written are earned on a daily pro rata basis over the terms of the policies. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Reinsurance premiums assumed are estimated based on information provided by ceding companies. The information used in establishing these estimates is reviewed and subsequent adjustments are recorded in the period in which they are determined. These premiums are earned over the terms of the related reinsurance contracts.
Loss and Loss Adjustment Expense Reserves
Unpaid losses and loss adjustment expenses are comprised of case reserves for known claims, incurred but not reported reserves for unknown claims and bulk reserves for any potential development for known claims, and reserves for the cost of
administration and settlement of both known and unknown claims. Such liabilities are established based on known facts and interpretation of circumstances, including the Company’s experience with similar cases and historical trends involving claim payment patterns, loss payments and pending levels of unpaid claims, as well as court decisions and economic conditions. The effects of inflation are implicitly considered in the reserving process. Establishing appropriate reserves is an inherently uncertain process; the ultimate liability may be in excess of or less than the amount provided. Any increase in the amount of reserves, including reserves for insured events of prior years, could have an adverse effect on the Company’s results for the period in which the adjustments are made. The Company utilizes its internal actuarial staff in establishing its reserves. The Company does not discount its loss and loss adjustment expense reserves.
The Company had a growing volume of assumed reinsurance between 1999 and 2002. Assumed reinsurance is a line of business with inherent volatility. Ultimate loss experience for the assumed reinsurance operation is based primarily on reports received by the Company from the underlying ceding insurers. Many losses take several years to be reported through the system. Ceding entities, representing over 61.5% of the reinsurance assumed business for the 1999 to 2003 underwriting years (based on gross written premiums), submit reports to the Company containing ultimate incurred loss estimates reviewed by independent or internal actuaries of the ceding entities. These reported ultimate incurred losses are the primary basis for the Company’s reserving estimates. In other cases, the Company relies on its own internal estimates determined primarily by experience to date, individual knowledge of the specific reinsurance contract, industry experience and other actuarial techniques to determine reserve requirements.
Because the reserve establishment process is by definition an estimate, actual results will vary from amounts established in earlier periods. The Company recognizes such differences in the periods they are determined. Since reserves accumulate on the balance sheet over several years until all claims are settled, a determination of inadequacy or redundancy could easily have a significant impact on earnings and therefore stockholders’ equity. The Company has established net reserves of $348.1 million and gross reserves of $378.4 million as of December 31, 2007 respectively, not including the retrospective reserves ceded under the Rosemont Re treaty. Reserves attributable to the operating segments of the Company are as follows:
SCPIE Holdings Inc.
Summary of Loss and LAE Reserves by Segment
For medical malpractice and other long tail liability lines of business, Bulk and IBNR reserves (which include loss adjustment expense reserves not allocated to specific cases) are the mathematical result of subtracting tabular case reserves from projected ultimate losses derived by the actuarial process. Bulk and IBNR reserves in the case of medical malpractice insurance written on a claims-made reporting policy do not generally represent late reported claims but rather expected upward case reserve movement which will be recognized as additional information develops on individual cases.
The relationship between Bulk and IBNR reserves and case reserves can be significantly different between lines of insurance as well as between individual companies. These differences may result from the length of time required to adequately investigate and evaluate individual cases, a company’s individual case reserving philosophy or other reasons.
Reserve Sensitivity
The Company’s operations, both currently and in the past, have been in areas of insurance considered long-tail lines of business. The long-tail reference relates to both the length of time it takes for claims to become known to an insurer and to be ultimately resolved. As a result of this extended length of time, an actuarial analysis of medical malpractice liability reserves and assumed reinsurance reserves is especially difficult. Small changes in the length of reporting or settlement patterns as well as in the average settlement amount caused by judicial decisions, inflation, catastrophes and foreign exchange rates can result in significant variability in projected reserve levels. In general, for these lines of business, the Company believes that a range plus or minus 10% from expected results is not considered an abnormality. This range reflects the uncertainly of the claim environment as well as the limited predicting power of past data. These uncertainties and limitations are not specific to the Company. A plus or minus 10% range around the Company’s net reserves held as of December 31, 2007 is a range of plus or minus $34.8 million. Such a range does not include all possible scenarios from a statistical distribution standpoint. The range represents a reasonable estimate of possible outcomes and should not be confused with a range of best estimates. The reserve selections represent the Company’s estimate of what it believes is the most probable outcome (best estimate) albeit the probability of any specific selection being exactly the ultimate result when all claims are paid and settled is very small.
The Company’s best estimate of reserves may change as credible data emerges. When the determination is made, resulting reserve changes are reflected in then-current operations. Due to the size of an insurance company’s reserves for losses, even a small change in estimates could have a material effect on results of operations for the period in which the change is made.
As an example of the potential variability of the estimate for loss and LAE reserves, the following table illustrates the impact on the level of reserves of potential changes in key assumptions related to the Company’s reserves:
The examples selected for inclusion in the preceding table are considered reasonably possible because
•
for the Core Healthcare Business, the primary decline in pure loss cost trend over the past several years has been driven primarily by decreases in the frequency of claims. Since the decrease in claim frequency is not attributable to any specific cause, this trend is not readily predictable and may be offset by increased severity if frequency declines relate primarily to historically smaller claims. The Company considers a 2 percentage point movement either up or down reasonably possible.
•
for the Non-Core Healthcare Reserves, the accuracy of the reserves is primarily dependent on the future settlement value of claims now known. Any particular legal award may be larger than current case reserves or, if the Company is successful in defense of the claim, less than current reserves. The Company believes there is a reasonable possibility further uncertainties of settlement could cause the average settlement value to increase or decrease 10%.
•
for the Assumed Reinsurance Reserves, the future reports from ceding companies could indicate the need for more reserves or less reserves depending on the circumstances of the individual contracts. The Company receives notice of increase and decreases in reserves every reporting period. The Company considers it reasonably possible that an increase or decrease of 10% could occur over time.
Core Healthcare Reserves
The primary factor affecting the adequacy of reserve estimates in the core area is the trend in pure loss costs (the combination of frequency and average severity changes) related to malpractice coverage. The inherent pure loss cost trend included in the setting of the 2005, 2006 and 2007 reserves has been 2.2%, 1.2% and 0.0% respectively. The primary factor which has decreased the pure loss cost trend during this timeframe has been a significant decline in the frequency of claims. The frequency of claims declined 21.1% in 2005, 4.6% in 2006 and 0.8% in 2007. The Company does not know of any empiric reason for the decline in claim frequency but believes it may represent a general decline in the propensity of claimants to sue or file claims against doctors after the great deal of publicity that surrounded the effect that medical malpractice insurance rates had on the practice of medicine in various parts of the country. The Company also believes this decline may be in smaller less meritorious claims. This may have the effect of increasing average severity. The Company believes other companies have reported in the media that this decline in frequency has occurred across the country as well as in California where the Company primarily operates. At 2007 reserve levels, a 1% change in pure loss costs trend produces a change in reserves of approximately $4.0 million. Such changes are reflected in the period of change. Reserves related to medical malpractice coverage account for over 95% of core reserves.
Non-Core Healthcare Reserves
The sensitivity of the Company’s reserves for non-core healthcare operations is impacted by two factors: frequency and severity. Because the non-core healthcare operations are comprised of claims-made policies that are in run-off, no significant number of new claims are expected. The severity of existing reported claims will be the principal determinant of ultimate reported losses. A change in the average severity of existing claims will have a proportional increase or decrease in reported reserves.
The net reserves for non-core healthcare operations as of December 31, 2007 consist of the following:
The following table shows the progress the Company has achieved in the disposition of the non-core healthcare claims.
As the individual cases mature and more information becomes available for evaluating individual cases, there is a declining need for Bulk and IBNR reserves. While the Company believes its reserves are adequate, several jurisdictions where the Company issued policies allow extended periods of time to elapse before the judicial or settlement process is completed. Individual settlements or judgments will determine the final incurred losses and thus the adequacy of these reserves. The recent experience has been generally consistent with Company expectations, but no assurance can be given that the Company’s current experience will continue. If the average settlement ultimately achieved is different by $15,000 for the current average reserve, the ultimate reserves will be affected by approximately $1.1 million.
Assumed Reinsurance Reserves
The accuracy and sensitivity of the Company’s reserves for Assumed Reinsurance is impacted primarily by three factors: the accuracy of case and IBNR reserves reported by the ceding companies on particular contracts; the timeliness of the reporting of losses from ceding companies; and the ultimate severity of large excess of loss claims.
The Company’s internal actuaries review the experience of individual contracts as well as review actuarial information received from the ceding companies. Since the last premiums were written on this business several years ago, the reporting of new losses should be relatively infrequent. The late reporting experienced by the Company does not appear to be related to any one type of contract or any specific contract and seems random in nature. These “surprises” would not normally be expected when looking at general reinsurance statistics relating to loss development.
In addition, because the Company is no longer in the reinsurance business, it is actively trying to commute certain contracts which may have a transaction cost to the Company but will improve its capital ratios under the A.M. Best capital adequacy model.
The Company holds net reserves (including retrospective reserves ceded under the Rosemont Re treaty of $5.7 million) of $35.2 million as of December 31, 2007. The net reserves consist of the following (in thousands):
The Occupational Accident reserves are provided to the Company by the internal actuary for the managing general agent in charge of the programs. The Company and its independent actuaries periodically review the resulting estimates of the managing general agent’s actuary for concurrence with his estimates. The remaining reserves involve approximately 33 separate contracts primarily involving high level excess of loss contracts, both property and casualty. These contracts are subject to periodic review by the Company’s internal and independent actuaries.
The Company believes that Occupational Accident reserves should be relatively stable at this point and the remaining reserves are based primarily on amounts currently reported to the Company by the ceding companies. As time passes, the ability of the underlying insureds to accurately reserve the large excess of loss type cases should improve. However, since the reporting of losses through the worldwide reinsurance market is often slow and is dependent upon the reporting by the ceding companies, the adequacy of these reserves has a potential for volatility and no assurances can be given that further adverse development will not occur. A 10% change in the reported losses would have resulted in a $3.5 million change in these reserves as of December 31, 2007.
Deferred Policy Acquisition Costs
Deferred policy acquisition costs include commissions, premium taxes and other variable costs incurred in connection with writing business. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed. Recoverability is analyzed based on the Company’s assumptions related to the underlying policies written, including the lives of the underlying policies, future investment income, and level of expenses necessary to maintain the policies over their entire lives. Deferred policy acquisition costs are amortized over the period in which the related premiums are earned.
Investments
The Company considers its fixed maturity and equity securities as available-for-sale securities. Available-for-sale securities are sold in response to a number of issues, including the Company’s liquidity needs, the Company’s statutory surplus requirements and tax management strategies, among others. During the fourth quarters of 2002 and 2003, the Company sold significant amounts of its available-for-sale securities to increase surplus for statutory accounting purposes. In late 2001 and 2002, the Company began to shift the character of its investment income to fully taxable in recognition of the Company’s current tax position. 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.
The Company evaluates the securities in its 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. A decline in the fair value of an available-for-sale security below cost that is judged to be other than temporary is realized as a loss in the current period and reduces the cost basis of the security.
The Company monitors its investments closely. The Company’s assessment of other-than-temporary impairments is security-specific as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been lower than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s intent to hold the securities until they mature or recover their value.
The current unrealized losses in fixed maturity securities are considered to be interest rate related. All fixed maturity securities held by the Company have paid all scheduled contractual obligations and the Company believes that each issuer has the ability to meet their remaining contractual obligations related to the security. The Company has the ability and intent to hold these securities to maturity.
Income taxes
At December 31, 2007, the Company had $31.9 million of net deferred income tax assets. Net deferred income tax assets consist of the net temporary differences created as a result of amounts deductible or revenue recognized in periods different for tax return purposes than for accounting purposes. These deferred income tax assets include an asset of $10.9 million for a $31.1 million net operating loss carryforward that will begin to expire in 2024. A net operating loss carryforward is a tax loss that may be carried forward into future years. It reduces taxable income in future years and the tax liability that would otherwise be incurred.
The Company believes it is more likely than not that the net deferred income tax assets will be realized through its future earnings. The Company will utilize an estimated $29.9 million of the net operating loss as of December 31, 2006, in its 2007 tax return.
RESULTS OF OPERATIONS-THREE YEAR COMPARISON
Direct Healthcare Liability Insurance-Background
The Company has been a leading writer of medical malpractice insurance for physicians and healthcare providers in California for many years. In 1996, the Company began expansion into other professional liability products and into other geographical markets. The principal product expansion was into professional liability insurance for hospitals. From 1997 through 1999, the Company added more than 75 hospitals to its program. These policies were written through national and regional brokers and covered facilities in four states outside California. At approximately the same time, the Company undertook a major geographic expansion in the physician and small medical group market through an arrangement with Brown & Brown, a leading publicly held insurance broker. This arrangement commenced in 1998, eventually encompassed nine states and in 2000 was expanded to include dentists in two states. During the same period, the Company also expanded into underwriting nonstandard physicians in a number of states outside California.
The Company encountered intense price competition in its hospital expansion efforts. During 2000, the Company incurred unacceptable losses under its hospital policies. The Company experienced adverse loss development in its prior years loss reserves for hospitals and significant ongoing losses in this program. The Company substantially reduced its hospital exposures during 2000 through policy nonrenewals and rate increases. At the beginning of 2001, it insured only 15 hospitals, and this was reduced to 10 hospitals at December 31, 2001, and the last hospital policy expired in December 2002.
In 2001, the Company recognized that the Brown & Brown and non-standard physician programs were seriously underpriced and implemented significant premium increases in its principal non-California markets. The Company also instituted more stringent underwriting and pricing guidelines in these states. Despite the significant price increases and more stringent underwriting guidelines, the non-California programs produced significant underwriting losses in 2002, 2003 and 2004. The Company and Brown & Brown agreed in early 2002 to terminate both the physician and dental programs no later than March 2003. This exposure is currently reserved and continues to decline over time.
During 2008, the Company will continue to concentrate its efforts on its core physician and medical group business in California and Delaware and settling outstanding claims in the non-core business.
Results of Operations-Direct Healthcare Liability Insurance
The Company underwrites professional and related liability policy coverages for physicians (including oral and maxillofacial surgeons), physician medical groups and clinics, hospitals, dentists, managed care organizations and other providers in the healthcare industry. As a result of the Company’s withdrawal from certain segments of the healthcare industry, the premiums earned are allocated between core and non-core premium. Core premium represents California and Delaware business excluding the Brown & Brown dental program and hospital business. Non-core business represents business related to physician and dental programs formerly conducted for the Company primarily in states outside California and Delaware by Brown & Brown, other state non-standard physician programs and hospital programs including those in California. The following tables summarize by core and non-core businesses the underwriting results of the direct healthcare liability insurance segment for the periods indicated:
Direct Healthcare Liability Insurance Segment
Underwriting Results
(In Thousands)
Core Business
Premiums written for the core direct healthcare liability insurance business decreased 1.7% and 2.8% in 2007 and 2006 and premiums earned decreased 1.0% in 2007 and 3.4% in 2006, respectively. The decrease in written and earned premium for 2007 and 2006 was primarily the result of decreases in premium related to loss rated policies as loss experience improved.
The Company has historically had a high renewal rate in its core business. The renewal rates of insureds who were offered renewal was 92% for 2007, 96% for 2006, and 95% for 2005. The deterioration in the renewal rate in 2007 was principally attributable to a chiropractors program that the Company insured for a number of years successfully. The program was controlled by a single agency who moved the business to a national competitor. Although the program represented a significant number of policies, total net annual premiums associated with the program was less than $1.5 million. The Company routinely loses insureds due to underwriting actions taken by the Company, or by insureds moving to competitors, leaving their practice, retiring or joining a health facility that provides for their insurance. These losses are offset by new sales activities. New policies written in 2007, 2006, and 2005, were 860, 868, and 1,077, respectively. The core business policies inforce at year end 2007, 2006, and 2005 were 9,767, 10,289, and 10,397 policies, respectively.
The loss ratio (loss and LAE related to premium earned) for 2007 was 62.0% compared to loss ratios of 70.6% and 70.9% for 2006 and 2005 respectively. The 8.6 percentage point decrease in the ratio between 2007 and 2006, and the 0.3 percentage point decrease in the ratio between 2006 and 2005, primarily reflects the fact that the frequency of claims declined 0.8% and 4.6% during these respective periods. The improved frequency trend resulted in re-estimations of previous years’ loss and LAE reserves that had an estimated favorable impact of 6 percentage points on the calendar year loss ratio in 2007. These declines were partially offset by increases in the estimate of the average cost of claims.
The underwriting expense ratio (expenses related to premiums earned) increased to 21.5% in 2007 compared to 20.7% and 20.3% in 2006 and 2005. The increase in 2007 was largely due to the effect of spreading expenses over a smaller premium base.
Non-Core Business
The premiums written and earned in 2005 were generated by policyholders exercising their right to purchase tail coverage.
No adjustments were made to overall reserve levels in 2007 and 2006 because experience related to new claims and average settlement amounts was consistent with actuarial expectations.
The Company has made significant progress in 2007 and 2006 in settling claims related to non-core healthcare liability business in run-off. Total net reserves declined from $60.6 million at December 31, 2005, to $37.7 million at December 31, 2006, and $23.9 million at December 31, 2007. Outstanding claims decreased from 229 at December 31, 2005, to 136 at December 31, 2006, and 75 at December 31, 2007. Six new claims were reported in 2007 compared to 11 in 2006 and 16 in 2005.
As the reserves and cases of non-core healthcare claims continue to decline, it becomes more difficult to establish reserve estimates for the remaining claims based on actuarial techniques. The ultimate losses become more related to specific case results, (including litigation) rather than estimates based on actuarial techniques. Unexpected legal verdicts or settlements reached at trial can produce unexpected reserve development.
Assumed Reinsurance-Background
Assumed reinsurance represents the book of assumed worldwide reinsurance of professional, commercial and personal liability coverages, commercial and residential property risks, accident and health and workers’ compensation coverages and marine coverages. Ultimate loss experience in this segment is based primarily on reports received by the Company from the underlying ceding insurers. Actual losses may take several years to be reported through the worldwide reinsurance system.
As a result of the Company’s decline in capital and surplus from the World Trade Center losses and losses incurred in healthcare insurance outside California, A. M. Best reduced the Insurance Subsidiaries ratings below the A- (Excellent) rating. Most ceding companies and companies in assumed reinsurance syndicates are reluctant to deal with insurers whose ratings are below A-. This fact made it difficult for the Company to remain in the assumed reinsurance market.
As a result, in December 2002 the Company entered into a quota share reinsurance transaction with Rosemont Reinsurance Ltd. (Rosemont Re) (formerly known as GoshawK Reinsurance Limited), a Bermuda reinsurance subsidiary of GoshawK Insurance Holdings plc, a publicly held London-based Lloyd’s underwriter (GoshawK), under which the Company ceded to Rosemont Re almost all of its unearned assumed reinsurance premiums as of June 30, 2002, together with written reinsurance premiums after that date, in each case related to the assumed reinsurance business for the 2001 and 2002 underwriting years. The Company retained certain losses related to the assumed reinsurance business, including those related to the World Trade Center, and the Company continued to participate in one Lloyd’s syndicate for the 2003 underwriting year. The Rosemont Re treaty relieved the Company of underwriting leverage and improved the Company’s risk-based capital adequacy ratios under both the A.M. Best and NAIC models.
Assets approximately equal to Rosemont Re’s estimated liabilities under its reinsurance agreement with the Company are currently held in trust to satisfy the liabilities under the agreement. If the estimated recoveries were to increase in the future, the Company would have to rely on Rosemont Re’s continuing ability to fund these amounts. As of June 30, 2007 Rosemont Re had $66.2 million of capital.
Results of Operations-Assumed Reinsurance Segment
The following table summarizes the underwriting results of the assumed reinsurance segment for the periods indicated:
The Company ceased writing assumed reinsurance business at the end of the 2003 underwriting year. Premiums written/(returned) and earned/(returned) in 2007 were primarily adjustments made for earlier periods.
The underwriting loss in 2007 related primarily to upward development on certain contracts and provisions for potential contract disputes.
The underwriting loss in 2006 related primarily to unexpected adjustments to World Trade Center losses reported to the Company in the latter part of the year and unexpected upward development principally on a number of London-based contracts.
The underwriting loss in 2005 was primarily attributable to (i) adjustments made to amounts ceded to Rosemont Re following a review by the parties in the third quarter, which resolved interpretative issues relating to the wording of the reinsurance contract, (ii) additional costs incurred with closing the last syndicate at Lloyd’s for which the Company provided capital, a
decision which was made in the fourth quarter and significantly improved the Company’s capital adequacy ratios under the A.M. Best capital adequacy model, and (iii) unexpected upward development on London-based business, including Lloyd’s syndicates.
Net loss reserves related to the assumed reinsurance segment declined from $59.2 million at December 31, 2005 to $49.0 million in 2006 and $35.2 million in 2007 as reserves were settled and programs were commuted.
The Rosemont Re reinsurance treaty entered into in December 2002 effectively ceded all of the unearned premium and future reported premium after June 30, 2002, for the assumed business written for underwriting years 2001 and 2002 by the Company. The treaty has no limitations on loss recoveries and includes a profit-sharing provision should the combined ratios calculated on the base premium ceded be below 100%. The treaty requires Rosemont Re to reimburse the Company for its acquisition and administrative expenses.
Other Operations
Net investment income increased to $21.9 million in 2007 from $20.4 million for 2006 and from $17.8 million in 2005. The changes in net investment income are primarily related to changes in short-term interest rates between periods, as the portfolio is very short in duration.
In 2007 the Company incurred $5.6 million in transaction expenses associated with the auction process and subsequent merger agreement executed with The Doctors Company.
In 2006 the Company incurred $1.6 million in expenses related to a proxy contest.
In 2005 the Company sold its stock interest in a privately held insurance company for a $4.4 million gain.
Income Taxes
The Company currently has a net deferred tax asset of $31.9 million as of December 31, 2007, of which $10.9 million relates to a $31.1 million net operating loss carryforward which begins to expire in 2024. The Company will be able to utilize this carryforward to reduce taxes in future periods. The losses which gave rise to the operating loss carryforward were primarily generated by underwriting losses in the non-core direct healthcare liability and assumed reinsurance businesses. Since these operations are now in run-off and the core business has historically been profitable on both a GAAP and tax basis, after consideration of investment income, the Company’s projections indicate that it is more likely than not that the net operating loss carryforward will be fully utilized within the carryforward period.
LIQUIDITY AND CAPITAL RESOURCES AND FINANCIAL CONDITION
The primary sources of the Company’s liquidity are insurance premiums, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. Funds are used to pay losses, LAE, operating expenses, reinsurance premiums and taxes.
Because of uncertainty related to the timing of the payment of claims, cash from operations for a property and casualty insurance company can vary substantially from period to period. The Company had positive cash flow from operations of $11.8 million in 2007 and $7.6 million in 2006 compared to 2005, when the Company had negative cash flow from operations of $30.2 million. The positive cash flow during 2007 is primarily related to core premium receipts and the decreasing claims payments associated with the non-core healthcare liability and assumed reinsurance programs, which are now in run-off. As the Company continues to pay-off non-core healthcare liability and assumed reinsurance reserves generated by prior years written premiums, the Company may again have negative cash flow from operations.
The Company maintains a significant portion of its investment portfolio in high-quality, short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and LAE. Cash and cash equivalents totaled $217.3 million, or 39.0% of invested assets, at December 31, 2007. The Company believes that all of its short-term and fixed-maturity securities are readily marketable. In addition, available current investment yields relative to available long-term yields have caused the Company to build up its short-term investments.
Generally, the Company invests its cash flow from operations principally in taxable fixed-maturity securities. The Company’s current policy is to limit its investment in unaffiliated equity securities and mortgage loans to no more than 8.0% of the total market value of its investments. The market value of the Company’s portfolio of unaffiliated equity securities was $1.7 million at December 31, 2007 and $2.0 million at 2006. The Company plans to refocus its emphasis on fixed-maturity securities investments.
The exposure to sub-prime residential mortgage lending is through a single issue within the Company’s fixed income investment portfolio that contains securities collateralized by mortgages that have characteristics of sub-prime lending. This investment is in the form of a collateral mortgage obligation supported by sub-prime mortgage loans. The collective carrying value of this investment is approximately $.2 million, representing less than 1/10 of 1 percent of the Company’s total fixed income investments, and had a Standard & Poor’s credit rating of AAA. This security was not considered as other than temporarily impaired as of December 31, 2007. While the Company’s exposure to sub-prime securities is not significant to the total investment portfolio, if the residential mortgage market continues to decline and / or the decline expands beyond the U.S. sub-prime, such circumstances could ultimately have an impact on other securities held within the investment portfolio.
The Company leases approximately 95,000 square feet of office space for its headquarters. The lease is for a term of 10 years ending in early 2009.
SCPIE Holdings is an insurance holding company whose assets primarily consist of all of the capital stock of its Insurance Subsidiaries. Its principal sources of funds are dividends from its subsidiaries and proceeds from the issuance of debt and equity securities. The Insurance Subsidiaries are restricted by state regulation in the amount of dividends they can pay in relation to earnings or surplus, without the consent of the applicable state regulatory authority, principally the California Department of Insurance. SCPIE Holdings’ principal insurance company subsidiary, SCPIE Indemnity, may pay dividends to SCPIE Holdings in any 12-month period, without regulatory approval, to the extent such dividends do not exceed the greater of (i) 10% of its statutory surplus at the end of the preceding year or (ii) its statutory net income for the preceding year. Applicable regulations further require that an insurer’s statutory surplus following a dividend or other distribution be reasonable in relation to its outstanding liabilities and adequate to meet its financial needs, and permit the payment of dividends only out of statutory earned (unassigned) surplus unless the payment out of other funds receives regulatory approval. The amount of dividends that SCPIE Indemnity is able to pay to SCPIE Holdings during 2008 without prior regulatory approval is approximately $31.9 million.
In March 2004, the Board of Directors suspended the Company’s quarterly dividends. The payment and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions. As of December 31, 2007, SCPIE Holdings held cash and short-term securities of $4.0 million. Based on historical trends, market conditions and its business plans, the Company believes that its sources of funds (including dividends from the Insurance Subsidiaries) will be sufficient to meet the liquidity needs of SCPIE Holdings over the next 18 months.
The Company’s capital adequacy position was weakened in the past by the losses in the non-core businesses. The Company’s current rating from A.M. Best is B+ (Good). In October 2007, following the Company’s announcement to be acquired by The Doctors Company, A.M. Best Co. placed the financial strength rating (FSR) of B+ (Good) under review with developing implications. In the year prior to the announcement, A.M. Best’s outlook for the Company was stable. A.M. Best assigns this rating to companies that have, in its opinion, a good ability to meet their current obligations to policyholders. The Company believes that it has strengthened its capital adequacy position at December 31, 2007, under the methodology followed by A.M. Best, but does not know whether this will result in a further rating change. The NAIC has developed a different methodology for measuring the adequacy of an insurer’s surplus which includes a risk-based capital (RBC) formula designed to measure state statutory capital and surplus needs. The RBC rules provide for different levels of regulatory attention based on four thresholds determined under the formula. At December 31, 2007, the RBC level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2007, SCPIE Indemnity’s adjusted surplus level of $195.8 million was 466% of this threshold.
The Company believes that it has the ability to fund its continuing operations from its premiums written and investment income. The Company plans to continue its focus on the efficient operation of its core business, while at the same time continuing to adjudicate and settle claims incurred in its discontinued non-core business. As the Company continues to run-off the non-core loss and LAE reserves, its capital adequacy position should improve.
The Company may determine that it is in its best interests to raise additional capital through financings to improve its financial position and grow its business. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company.
CONTRACTUAL COMMITMENTS
The Company has certain contractual obligations and commercial commitments principally for providing for the payments of loss and LAE expenses, operating leases for office space for its headquarters and letters of credit to provide security in connection with the assumed reinsurance segment. The table below presents the contractual payments estimated to be due by period or expiration period for each obligation or commitment:
Contractual commitments as of December 31, are as follows:
Unlike many other forms of contractual obligations, loss and LAE reserves do not have definitive due dates, and the ultimate payment dates are subject to a number of variables and uncertainties. The liability shown in the table represents the Company’s best estimate of the unpaid cost of settling claims, including claims that have been incurred but not yet reported, and the time period in which such claims will be resolved. The amounts shown are gross of any reinsurance that the Company estimates will be recoverable on resolution of the claims.
The Company has a letter of credit facility in the amount of $25 million with Union Bank of California. Letters of credit issued under the facility collateralize loss reserves under reinsurance contracts. As of December 31, 2007, letter of credit issuance under the facility was approximately $16.1 million. Securities of $16.1 million are pledged as collateral under the facility.
EFFECT OF INFLATION
The primary effect of inflation on the Company is considered in pricing and estimating reserves for unpaid losses and LAE for claims in which there is a long period between reporting and settlement, such as medical malpractice claims. The actual effect of inflation on the Company’s results cannot be accurately known until claims are ultimately settled. Based on actual results to date, the Company believes that loss and LAE reserve levels and the Company’s rate making process adequately incorporate the effects of inflation.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to various market risk exposures, including interest rate risk and equity price risk.
The Company invests its assets primarily in fixed-maturity securities, which at December 31, 2007, comprised 60.7% of total investments at market value. Corporate bonds represent 46.2% and U.S. government bonds represent 34.9% of the fixed-maturity investments, with the remainder consisting of mortgage-backed and asset-backed securities. Equity securities, consisting primarily of common stocks, account for .3% of total investments at market value. The remainder of the investment portfolio consists of cash and highly liquid short-term investments, which are primarily overnight bank repurchase agreements and short-term money market funds.
The value of the fixed-maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio increases with the opposite holding true in rising interest rate environments. A common measure of the interest sensitivity of fixed-maturity assets is modified or effective duration, a calculation that takes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. The effective duration of the fixed-maturity portfolio at December 31, 2007 was 2.8 years.
The value of the common stock equity investments is dependent upon general conditions in the securities markets and the business and financial performance of the individual companies in the portfolio. Values are typically based on future economic prospects as perceived by investors in the equity markets.
At December 31, 2007, the investment portfolio included $2.2 million in net unrealized gains. At December 31, 2006, the investment portfolio included $7.3 million in net unrealized losses.
The Company’s invested assets are subject to interest rate risk. The following table presents the effect on current estimated fair values of the fixed-maturity securities available for sale and common stocks assuming a 100-basis-point (1.0%) increase in market interest rates and a 10% decline in equity prices.
*
Adjusted interest rates assume a 100-basis-point (1.0%) increase in market rates
**
Adjusted equity prices assume a 10% decline in market values
For all its financial assets and liabilities, the Company seeks to maintain reasonable average durations, consistent with the maximization of income, without sacrificing investment quality and providing for liquidity and diversification.
The estimated fair values at current market rates for financial instruments subject to interest rate risk in the table above are the same as those disclosed in Note 2 to Consolidated Financial Statements. The estimated fair values at the adjusted market rates (assuming a 100-basis-point increase in market interest rates) are calculated using discounted cash flow analysis and duration modeling where appropriate. The estimated values do not consider the effect that changing interest rates could have on prepayment activity (e.g., mortgages underlying mortgage-backed securities).
This sensitivity analysis provides only a limited, point-in-time view of the market risk sensitivity of certain of the Company’s financial instruments. The actual impact of market interest rate and price changes on the financial instruments may differ significantly from those shown in the sensitivity analysis. The sensitivity analysis is further limited, as it does not consider any actions the Company could take in response to actual and/or anticipated changes in interest rates and equity prices.
The Company’s fixed income investment portfolio contains securities collateralized by mortgages that have characteristics of sub-prime lending. While the Company’s exposure to sub-prime securities is not significant to the total investment portfolio, if the residential mortgage market continues to decline and / or the decline expands beyond the U.S. sub-prime, such circumstances could ultimately have an impact on other securities held within the investment portfolio, and therefore, on the Company’s liquidity.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company’s Consolidated Financial Statements and related notes, including supplementary data, are set forth in the “Index” on page 58 hereof.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (SEC), and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
Management’s Report on Internal Control over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934.
The Company has conducted an evaluation under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of its internal control over financial reporting as of December 31, 2007 based in the criteria related to internal control over financial reporting described in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, the Company’s management, including its Chief Executive Officer and Chief Financial Officer, concluded that its internal control over financial reporting was effective as of December 31, 2007 in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Ernst & Young LLP, an independent registered public accounting firm, has issued an audit report on the Company’s internal control as of December 31, 2007, a copy of which is included in this Annual Report on Form 10-K.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of SCPIE Holdings Inc.
We have audited SCPIE Holdings Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, SCPIE Holdings Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of SCPIE Holdings Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 of SCPIE Holdings Inc. and subsidiaries and our report dated March 14, 2008 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Los Angeles, California
March 14, 2008
Changes In Internal Control Over Financial Reporting
During the fiscal quarter ended December 31, 2007, there have been no changes in the Company’s internal control over financial reporting that may have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The names of the executive officers of the Company and their ages, titles and biographies as of the date hereof are incorporated by reference from Part I, Item 1, above.
The following information is included in the Company’s Notice of Annual Meeting of Stockholders and Proxy Statement to be filed within 120 days after the Company’s fiscal year end of December 31, 2007 (the “Proxy Statement”) and is incorporated herein by reference:
Information regarding directors of the Company is set forth under “Election of Directors.”
Information regarding the Company’s Audit Committee and designated “audit committee financial expert” is set forth under “Election of Directors-Meetings and Committees of the Board.”
Information on the Company’s code of business conduct and ethics for directors, officers and employees, is set forth under “Election of Directors-Code of Business Conduct and Ethics.”
Information under Section 16A beneficial ownership reporting compliance is set forth under “Stock Ownership” and “Section 16(A) Beneficial Ownership Reporting Compliance.”
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Executive Compensation.”
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Stock Ownership.”
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Certain Relationships and Related Transactions.”
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Principal Accountant Fees and Services.”
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES
(a)(1) and (a)(2) and (a)(3) FINANCIAL STATEMENTS AND SCHEDULES.
Reference is made to the “Index-Financial Statements and Financial Statement Schedules-Annual Report on Form 10-K” filed on page 55 of this Form 10-K report.
(a)
(3) Exhibits:
*
Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
March 14, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SCPIE HOLDINGS INC.
ITEM 15(a)(3) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
ANNUAL REPORT ON FORM 10-K
INDEX
PAGE
Report of Independent Registered Public Accounting Firm
Financial Statements:
Consolidated Balance Sheets as of December 31, 2007 and 2006
Consolidated Statements of Income for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
Schedule II-Condensed Financial Information of Registrant
Schedule III-Supplementary Insurance Information
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of SCPIE Holdings Inc.
We have audited the accompanying consolidated balance sheets of SCPIE Holdings Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of SCPIE Holdings Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), SCPIE Holdings Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2008 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Los Angeles, California
March 14, 2008
SCPIE HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, except share data)
See accompanying notes to Consolidated Financial Statements.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, except per-share data)
See accompanying notes to Consolidated Financial Statements.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See accompanying notes to Consolidated Financial Statements.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
See accompanying notes to Consolidated Financial Statements.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION AND NATURE OF OPERATIONS
The accompanying consolidated financial statements include the accounts and operations of SCPIE Holdings Inc. (SCPIE Holdings) and its direct and indirect wholly owned subsidiaries, principally SCPIE Indemnity Company (SCPIE Indemnity), American Healthcare Indemnity Company (AHI), American Healthcare Specialty Insurance Company (AHSIC), SCPIE Underwriting Limited (SUL) and SCPIE Management Company (SMC), collectively, the Company. Significant intercompany accounts and transactions have been eliminated in consolidation.
The Company principally writes professional liability insurance for physicians, oral and maxillofacial surgeons, and other healthcare providers in California and Delaware. Most of the Company’s coverage is written on a “claims-made and reported” basis. This coverage is provided only for claims that are first reported to the Company during the insured’s coverage period and that arise from occurrences during the insured’s coverage period. The Company also makes “tail” coverage available for purchase by policyholders in order to cover claims that arise from occurrences during the insured’s coverage period, but that are first reported to the Company after the insured’s coverage period and during the term of the applicable tail coverage.
Between 2002 and 2004 the Company withdrew from its healthcare liability insurance operations in states other than California and Delaware. During the same period, the Company also exited the assumed reinsurance business. The Company continues to run-off the liabilities associated with these non-core operations.
On October 15, 2007, the Company agreed to be acquired by The Doctors Company for $28.00 in cash for each outstanding share of Company common stock in a merger transaction valued at approximately $281.1 million. The merger is subject to customary closing conditions, including, among others, (i) the approval of the merger by the holders of a majority in voting power of the outstanding common stock of the Company; (ii) the approval of the merger by the Departments of Insurance of California, Delaware and Arkansas; (iii) the receipt of antitrust approvals, or the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; and (iv) the absence of any order or injunction prohibiting the consummation of the merger. The Company currently expects the merger to close during the first half of 2008. However, it is possible that factors outside of the Company’s control could require the parties to complete the proposed merger at a later time or not to complete it at all.
The preparation of financial statements of insurance companies requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The significant accounting policies followed by the Company that materially affect financial reporting are summarized below:
FOREIGN OPERATIONS
SUL, a corporate member of Lloyd’s of London (Lloyd’s), commenced operations in January 2001 as a capital provider to three underwriting syndicates. In 2003, the Company provided Lloyd’s capital in support of one syndicate. No Lloyd’s syndicate was supported in 2004. SUL no longer has underwriting operations.
INVESTMENTS
Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of each balance sheet date.
Available-for-sale-Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of tax, reported in other comprehensive income. The net carrying value of fixed-maturity investments classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity, or in the case of mortgage-backed securities, over the estimated life of the security. Such amortization is computed under the effective interest method and included in net investment income. Interest and dividends are recorded in net investment income. Interest is recognized on an accrual basis and dividends are recognized on the date of record. Realized gains and losses, and declines in value judged to be other-than-temporary are recorded in realized investment gains (losses). The cost of securities sold is based on the specific identification method.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Investments in 20% to 50%-owned affiliates are accounted for on the equity method and investments in less than 20% owned affiliates are accounted for on the cost method. Earnings on the Company’s one equity method investment is included in investment income and is classified with common stocks.
The Company has no securities classified as “held to maturity” or “trading” as defined in Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Investments.
Cash and Cash Equivalents-Short-term investments with a maturity of three months or less at date of purchase are included in cash and cash equivalents and are carried at cost, which approximates fair value.
DEFERRED POLICY ACQUISITION COSTS
Costs of acquiring insurance business that vary with and are primarily related to the production of such business are deferred and amortized ratably over the period the related premiums are recognized. Such costs include commissions, premium taxes and certain underwriting and policy issuance costs. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.
PREMIUMS
Premiums are recognized as earned on a daily pro-rata basis over the terms of the respective policies.
Premium receivables are recorded net of an estimated allowance for uncollectible amounts. The allowance for uncollectible premiums was $205,000 and $295,000 as of December 31, 2007, and 2006, respectively.
RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Reserves for losses and loss adjustment expenses (LAE) represent the estimated liability for reported claims plus those incurred but not yet reported and the related estimated costs to adjust those claims. The reserve for losses and LAE is determined using case-basis evaluations, statistical analysis and reports from ceding entities and represents estimates of the ultimate cost of all unpaid losses incurred through December 31 of each year. Although considerable variability is inherent in such estimates, management believes that the reserve for unpaid losses and related LAE is adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations and are accounted for as changes in estimates.
EARNINGS PER SHARE
Basic earnings per share are calculated by dividing net income by the weighted-average number of common shares outstanding during the year. Diluted earnings per share include the weighted-average common shares outstanding during the year plus the weighted-average of potential dilutive common shares outstanding during the year. Potential dilutive common shares include restricted stock rights and outstanding stock options, which are calculated using the treasury stock method.
INCOME TAXES
The Company files a consolidated U.S. income tax return. Income taxes are accounted for using the liability method. The provision for income taxes has two components, amounts currently payable or receivable and deferred amounts. We recognize deferred income taxes for temporary differences-the differences between the GAAP financial statement carrying amounts of
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
assets and liabilities and those required to be used in the tax return. Such temporary differences relate primarily to net operating loss carryforwards, alternative minimum tax, and differences in the recognition of deferred policy acquisition costs, loss and loss adjustment expense reserves, and unearned premiums. The tax effects of these temporary differences are recognized as deferred income tax assets and liabilities on the Consolidated Balance Sheets.
REINSURANCE
Prospective reinsurance premiums, losses and loss adjustment expenses are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and depreciated principally under the straight-line method over the useful life of the assets that range from five to seven years. Property and equipment consist of the following:
Depreciation expense was $815,000 in 2007, $811,000 in 2006 and $821,000 in 2005.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Estimated fair value amounts, defined as the quoted market price of a financial instrument, have been determined using available market information and other appropriate valuation methodologies. However, considerable judgments are required in developing the estimates of fair value where quoted market prices are not available. Accordingly, these estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimating methodologies may have an effect on the estimated fair value amounts.
The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying consolidated financial statements and in these notes:
Cash, premiums receivable, and accrued expenses and other liabilities: The carrying amounts for these financial instruments as reported in the accompanying consolidated balance sheets approximate their fair values.
Investments: The estimated fair values for available-for-sale securities generally represent quoted market value prices for securities traded in the public marketplace or estimated values for securities not traded in the public marketplace. Additional data with respect to fair values of the Company’s investment securities are disclosed in Note 2.
Other financial instruments qualify as insurance-related products and are specifically exempted from fair value disclosure requirements.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
CREDIT RISK
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of fixed-maturity investments. Concentrations of credit risk with respect to fixed maturities are limited due to the large number of such investments and their distributions across many different industries and geographics.
The Company’s ceded reinsurance program is placed with a key number of individual companies and syndicates at Lloyd’s of London to minimize a concentration of credit risk.
For the year ended December 31, 2007, the recoverable from reinsurers was approximately $36.2 million. The reinsurance recoverable is summarized as follows:
*
Amounts are fully collateralized by a trust held for the benefit of the Company.
SHARE-BASED COMPENSATION
The Company has a share-based employee and non-employee compensation plan more fully described in Note 9.
The Company accounts for stock options under the recognition and measurement principles of SFAS No. 123(R), share-based payments issued December 16, 2004. Prior to the adoption of SFAS No. 123(R) on January 1, 2006, the Company accounted for stock options under SFAS No. 123 using the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations (collectively referred to as APB 25).
NEW ACCOUNTING STANDARDS
In June 2006, the FASB issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes (FIN 48), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance in derecognition, measurement, classification, interest and penalties, accounting for interim periods, disclosure and transition. The Company adopted FIN 48 as of January 1, 2007. The impact on the consolidated balance sheets and statements of shareholders’ equity was a reduction of $228,000.
SFAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plan-an Amendment of FASB Statements 87, 88, 106 and 132(R)-in September 2006, the FASB issued SFAS 158, which requires the over-funded or under-funded status of defined benefit and other postretirement plans to be recognized as an asset or liability on the consolidated balance sheet. Actuarial gains and losses and prior service costs and credits that have not yet been recognized as a component of net periodic benefit cost as of the statement adoption date are recorded as a component of accumulated other comprehensive income (AOCI). The Company adopted SFAS 158 as of December 31, 2006 and recorded an adjustment to AOCI of $344,000.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SFAS 157, Fair Value Measurements-In September 2006, the FASB issued SFAS 157, which establishes a framework for measuring fair value and requires expanded disclosure about the information used to measure fair value. The statement applies whenever other statements require, or permit, assets or liabilities to be measured at fair value. The statement does not expand the use of fair value in any new circumstances and is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted this statement as of January 1, 2008, and the impact on the Company’s financial condition or results of operations was not material.
SFAS 159, Fair Value Option for Financial Assets and Financial Liabilities-In February 2007, the FASB issued SFAS 159, which permits entities to voluntarily choose to measure eligible items at fair value at specified election dates. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, the statement specifies that entities report unrealized gains and losses at each subsequent reporting date in earnings. The statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company adopted SFAS 159 on January 1, 2008. The adoption of the statement did not impact the Company’s financial condition or results of operations as management did not elect the fair value option for any of its instruments.
RECLASSIFICATIONS
Certain prior-year amounts have been reclassified to conform to the current-year presentation.
NOTE 2. INVESTMENTS
The Company’s investments in available-for-sale securities are summarized as follows:
The fair values of fixed-maturity securities and equity securities are based on quoted market prices, where available.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The amortized cost and fair value of the Company’s investments in fixed-maturity securities as of December 31, 2007, are summarized by stated maturities as follows:
The foregoing data is based on the stated maturities of the securities. Actual maturities will differ for some securities because borrowers may have the right to call or prepay obligations.
Major categories of the Company’s investment income are summarized as follows:
Realized gains and losses from sales of investments are summarized as follows:
The change in the Company’s unrealized appreciation (depreciation), net of income taxes, on fixed-maturity securities was $6.2 million, $(0.3) million and $(8.4) million for the years ended December 31, 2007, 2006 and 2005 respectively; the corresponding amounts for equity securities were $0.0 million, $(0.1) million, and $(3.9) million.
The Company monitors its investments closely. If an unrealized loss is determined to be other-than-temporary, it is written down as a realized loss through the consolidated statements of income. The Company’s assessment of other-than-temporary impairments is security-specific as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been lower than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s intent to hold the securities until they mature or recover their value.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The current unrealized losses in fixed maturity securities is considered to be interest rate related. All fixed maturity securities held by the Company have paid all scheduled contracted obligations and the Company believes that each issuer has the ability to meet their remaining obligations related to the security. The Company has the ability and intent to hold these securities to maturity.
The Company held 59 investment positions with unrealized losses as of December 31, 2007. The Company held 55 securities that were in an unrealized loss position for 12 months or more.
The Company held 106 investment positions with unrealized losses as of December 31, 2006. All of the investments were investment grade and the unrealized losses were primarily due to interest rate fluctuations. The Company held 100 securities that were in an unrealized loss position for 12 months or more.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 3. LOSSES AND LOSS ADJUSTMENT EXPENSES
The following table provides a reconciliation of the beginning and ending reserve balances, net of reinsurance recoverable, for 2007, 2006 and 2005.
The decreases during 2007, 2006 and 2005 in estimated losses and LAE occurring in prior years were primarily attributable to favorable loss experience in direct healthcare liability insurance due to the declining frequency in claims in both years and non-core direct healthcare liability insurance in 2006 and 2005, partially offset by adverse experience in the assumed reinsurance business.
The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and LAE. While anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the individual type of insurance written. Future average severities are projected based on historical trends adjusted for implemented changes in underwriting standards, policy provisions, and general economic trends. Those anticipated trends are monitored based on actual development and are modified if necessary.
NOTE 4. REINSURANCE
Certain premiums and benefits are ceded to other insurance companies under various reinsurance agreements. These reinsurance agreements provide the Company with increased capacity to write additional risks and maintain its exposure to loss within its capital resources. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Some of these agreements include terms whereby the Company earns a profit-sharing commission if the reinsurer’s experience is favorable.
Reinsurance contracts do not relieve the Company from its obligations to policyholders. The failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition and economic characteristics of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company generally does not require collateral from its reinsurers that are licensed to assume such business.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The effect of reinsurance on premiums written and earned are as follows (in thousands):
Assumed reinsurance receivable is recorded net of an estimated allowance for uncollectible amounts. The allowance for uncollectible assumed reinsurance receivable was $1.7 million at December 31, 2007. No allowance was recorded at December 31, 2006.
Reinsurance ceded reduced (increased) loss and loss adjustment expenses incurred by $0.9 million, $(2.8) million, and $(15.0) million in 2007, 2006 and 2005, respectively. Reinsurance ceded also reduced loss and loss adjustment expense reserves by $30.3 million, $38.2 million, and $45.5 million in 2007, 2006 and 2005, respectively.
From 2002 through 2007 the Company has reinsured losses above a retention of approximately $2.0 million to $20.0 million subject to an aggregate deductible of $3.0 million in each respective year for losses in excess of the Company’s retention. For 2003 and 2002 the Company also reinsured losses in excess of $20.0 million up to $50.0 million subject to 16% and 8% Company participation in these reinsurance layers, respectively. For 2001 and 2000 the Company reinsured losses above a $1.25 million and $2.0 million retention respectively up to $70.0 million subject to a $3.0 million aggregate deductible for each year. Prior to 2000 the Company generally reinsured losses up to $20.0 million above a $1 million retention subject to a $1 million aggregate deductible.
In 1999, the Company formed an assumed reinsurance division and rapidly expanded this operation. In December 2002, the Company retroceded most of its assumed reinsurance business, as it no longer was considered part of the Company’s core business, and the Company began refocusing on its core business of healthcare liability insurance. In December 2002, SCPIE Indemnity and its two wholly owned insurance subsidiaries, AHI and AHSIC, entered into a reinsurance agreement with Rosemont Re whereby they ceded the majority of the written and earned premium related to their assumed reinsurance program after July 1, 2002. The Rosemont Re agreement covers the 2001 and 2002 underwriting years of the assumed business. Under the agreement, the reinsurer will reimburse the Companies for losses occurring after June 30, 2002, on an unlimited basis and their direct acquisition costs. Losses related to premiums earned prior to July 1, 2002, remain the responsibility of the Company. This includes losses related to the World Trade Center terrorist attack.
The Rosemont Re reinsurance agreement has both prospective and retroactive elements as defined in SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. As such, any gains under the contract will be deferred and amortized to income based upon the expected recovery. No gains are anticipated currently. Losses related to future earned premium ceded, as well as potential upward development on losses related to existing earned premium ceded after June 30, 2002, will ultimately determine whether a gain will be recorded under the contract.
The Rosemont Re reinsurance agreement provides that funds are held in trust for the benefit of the Company to collateralize obligations under the agreement. As of December 31, 2007, the fair market value of the assets held in the trust was $29.4 million. Further, the agreement contains a profit-sharing mechanism, which states that the Company will receive 50% of the profits if the combined ratio is below 100% (excluding the contract’s provision for additional premiums paid). Based on the experience to date, no profit-sharing has been accrued or paid.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 5. INCOME TAXES
The components of the income tax expense (benefit) reported in the accompanying consolidated statements of income are summarized as follows:
A reconciliation of income tax expense computed at the federal statutory tax rate to total income tax expense is summarized as follows:
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are summarized as follows:
Net deferred income tax assets consist of the net temporary differences created as a result of amounts deductible or revenue recognized in periods different for tax return purposes than for accounting purposes. These deferred income tax assets include
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
an asset of $10.9 million for a net operating loss carryforward that will begin expiring in 2024. A net operating loss carryforward is a tax loss that may be carried forward into future years. It reduces taxable income in future years and the tax liability that would otherwise be incurred.
The Company believes it is more likely than not that the net deferred income tax assets will be realized through its future earnings. The Company’s core operations have historically been profitable on both a GAAP and tax basis. However, in 2007, the Company established a $1.1 million valuation allowance for deferred tax asset amounts related to the transaction costs capitalized with respect to the merger with The Doctors Company. The losses incurred in 2001 to 2004 were primarily caused by losses in the non-core healthcare and assumed reinsurance businesses. Since the core healthcare liability operation has improved over the past years and the non-core healthcare liability and assumed operations are now in run-off, the Company has returned to a position of taxable income, thus enabling it to begin utilizing the net operating loss carryforward.
The Company’s estimate of future taxable income uses the same assumptions and projections as in its internal financial projections. These projections are subject to uncertainties primarily related to future underwriting results.
At the December 31, 2007, $350,000 of gross unrecognized tax benefits were reflected in the Consolidated Balance Sheet, $228,000 of which would affect the effective tax rate if recognized. The difference between the gross unrecognized tax benefits and the amount that would affect the effective tax rate is attributable to the federal tax benefit for state income taxes.
The change in the amount of unrecognized tax benefits in the next 12 months, if any, is not expected to have a significant impact on the Company’s results of operations or financial position.
Interest accrued related to unrecognized tax benefits is recognized in Income Taxes and penalties in Other Underwriting and Other Operating Expenses in the Consolidated Statements of Income. Calendar years 2003 through 2007 remain subject to IRS examination and the IRS examinations for calendar years 2002 and prior have been completed.
NOTE 6. STATUTORY ACCOUNTING PRINCIPLES
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices. The statutory financial statements for the Company’s insurance subsidiaries, are completed in accordance with the National Association of Insurance Commissioners’ Accounting Practices and Procedures manual, (NAIC SAP). The NAIC SAP has been fully adopted by the Arkansas, California and Delaware Departments of Insurance. The principal differences between financial statement net income and statutory net income are due to policy acquisition costs, which are deferred under GAAP but expensed for statutory purposes and deferred income taxes. Policyholders’ surplus and net income for the Company’s insurance subsidiaries, as determined in accordance with statutory accounting practices, are summarized as follows:
The Company was issued a permitted practice letter by the California Department of Insurance that was in effect for the year ended December 31, 2005 allowing the Company to admit, on a statutory basis, assets pledged by the insurance subsidiaries as security for the letter of credit used to support the Lloyd’s capital requirement of SCPIE Underwriting Limited. The effect of treating the pledged assets as non-admitted as of December 31, 2005 would have been to reduce statutory surplus of SCPIE Indemnity by approximately $30.3 million.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Generally, the capital and surplus of the Company’s insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries’ capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements; however, payments of the amounts as dividends may be subject to approval by regulatory authorities. At December 31, 2007, the amount of dividends available to SCPIE Holdings from its insurance subsidiaries during 2008 not limited by such restrictions is approximately $31.9 million.
NOTE 7. BENEFIT PLANS
The Company has 401(k) defined contribution, supplemental executive retirement, and noncontributory defined benefit pension plans, which provide retirement benefits to its employees. Under the 401(k) plan, the Company contributes a 200% matching contribution based on the first 3% of an employee’s compensation plus a discretionary contribution of 1% of an employee’s compensation. Company contributions to the 401(k) plan were $663,000 in 2007, and $701,000 in 2006 and $762,000 in 2005.
Effective December 31, 2000, the Company’s defined benefit pension plan was amended to freeze accrued benefits for all active participants. Participants in the defined benefit pension plan continue to accrue service for vesting purposes only. Effective January 1, 2001, no future employees were eligible to participate in the plan.
In February 2004, the Company amended the supplemental executive retirement plan to freeze the benefits accrued to vested participants as of the date of the amendment and cease any further vesting of benefits under the plan. There were four vested executives as of the date of the amendment.
The net pension expense for these plans consists of the following components:
Pension expense for all plans was $0.9 million, $1.1 million, and $1.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table sets forth the funding status of the plans:
The investment policy for the defined benefit pension plan involves employing a sufficient level of flexibility to provide for investment opportunities as they occur, while maintaining reasonable assurance that the investment programs are consistent with its obligations. The assets are managed on a total return basis, whereby a mix of equity securities, debt securities and cash, is targeted to maximize the long-term return on assets for a given level of risk. Investment risk is measured and monitored on an ongoing basis by plan trustees through periodic portfolio reviews and annual liability measurements.
*
Expected contributions reflect the minimum amount expected to be contributed to funded plans and amount paid from corporate assets for other plans.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During 1999, the Company implemented the Director and Senior Management Stock Purchase Plan. The directors and senior managers purchased a total of 145,000 shares of common stock under this plan. The eligible participants executed promissory stock subscription notes in the aggregate amount of $4.1 million to fund this purchase. As of December 31, 2007, $2.6 million of the promissory stock subscription notes had been repaid.
The Company’s Employee Stock Purchase Plan offers eligible employees the opportunity to purchase shares of SCPIE Holdings Inc. common stock through payroll deductions.
NOTE 8. COMMITMENTS AND CONTINGENCIES
In July 1998, the Company entered into a lease covering approximately 95,000 square feet of office space for the Company headquarters. The lease has escalating payments over a term of 10 years ending early 2009. Occupancy expense for the years ended December 31, 2007, 2006 and 2005 was $2.8 million, $3.2 million, and $3.1 million, respectively. Future minimum payments under noncancelable operating leases with initial terms of one year or more consist of the following at December 31, 2007 (in thousands):
The Company is named as a defendant in various legal actions primarily arising from claims made under insurance policies and contracts. These actions are considered by the Company in estimating the loss and loss adjustment expense reserves. The Company’s management believes that the resolution of these actions will not have a material adverse effect on the Company’s financial position or results of operations.
Highlands Insurance Group
The Company is obligated to assume certain policy obligations of Highlands Insurance Company (Highlands) in the event Highlands is declared insolvent by a court of competent jurisdiction and is unable to pay these obligations. The coverages principally involve workers’ compensation, commercial automobile and general liability. Highlands currently is under the jurisdiction of the Texas District Court which appointed the Texas Insurance Commissioner as a permanent Receiver of
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Highlands in November 2003. The Receiver, through a Special Deputy Receiver (“SDR”) continues to resolve Highlands claim liabilities and otherwise conduct its business as part of his efforts to rehabilitate Highlands. At December 31, 2007, Highlands had established case loss reserves of $2.8 million, net of reinsurance, for the subject policies. Based on a limited review of the exposures remaining, the Company estimates that incurred but not reported (“IBNR”) losses are $2.4 million, for a total loss and loss adjustment expenses (“LAE”) reserve of $5.2 million. This estimate is not based on a full reserve analysis of the exposures and is not recorded in the Company’s reserves. If Highlands is declared insolvent and liquidated by court order, the Company would likely be required to assume Highlands’ remaining obligations under the subject policies.
The receiver has filed a rehabilitation plan with the Texas Court. A hearing on that plan is scheduled for May 12, 2008. In the interim, Highlands continues to pay and settle claims as the Receivership remains in place.
Letters of Credit
The Company has a letter of credit facility in the amount of $25 million with Union Bank of California. Letters of credit issued under the facility fulfill the collateral requirements and guarantee loss reserves under certain other reinsurance contracts. As of December 31, 2007, letter of credit issuance under the facility was approximately $16.1 million. Securities of $16.1 million are pledged as collateral under the facility.
At December 31, 2007, the Company’s investments in fixed-maturity securities with a fair value of $9.1 million were on deposit with state insurance departments to satisfy regulatory requirements.
NOTE 9. SHARE-BASED COMPENSATION
The Company has a share-based compensation plan, the 2003 Amended and Restated Equity Participation Plan of SCPIE Holdings Inc. (the Plan), which provides for grants of stock options to key employees and non-employee directors, grants of restricted shares to non-employee directors, and stock appreciation rights (SARs) to key employees of the Company.
The aggregate number of options for common shares issued and issuable under the Plan is limited to 1,700,000. All options granted have 10-year terms and vest over various future periods.
Effective January 1, 2006, the Company adopted SFAS 123(R), “Share-Based Payment,” which requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements based on the grant-date fair value of the award, recognized over the period the employee is required to perform services in exchange for the award (presumptively the vesting period.)
The Company adopted SFAS 123(R) using the modified-prospective method. Under the modified-prospective method, prior periods are not restated. However, for awards granted prior to the date of adoption that are unvested on the adoption date, compensation cost is recognized prospectively. In periods after adoption, compensation cost is recognized over the remaining service period related to the award, based on amounts previously reported in the pro forma disclosures required under SFAS 123. Compensation cost is also recognized for awards granted after the effective adoption date based on the grant-date fair value of the award, calculated and recognized under the measurement provisions of SFAS 123(R).
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
A summary of the Company’s stock-option activity and related information follows:
Information about stock options outstanding at December 31, 2007, is summarized as follows:
The aggregate intrinsic value of options outstanding and exercisable at December 31, 2007 was $11.4 million and $11.3 million, respectively. The weighted-average remaining contractual term (in years) was 4.38 for options exercisable as of December 31, 2007. The intrinsic value of options exercised was $130,000, $689,000 and $303,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
A summary of the Company’s SARs activity and related information follows:
The Company expensed as compensation $0.1 million and $0.5 million for SARs in 2006 and 2005, respectively. All SARS were fully exercised in 2006 and prior.
Non-employee directors of the Company receive a grant of 2,000 restricted shares each year as part of their compensation. The restricted share grants vest on the one-year anniversary of the grant. In 2007, 2006 and 2005, the Company issued 18,000, 20,000 and 20,000 restricted share grants to non-employee directors and expensed as compensation $0.5 million, $0.4 million, and $0.3 million respectively.
Prior to the adoption of SFAS 123(R), the Company applied the intrinsic-value provisions set forth in APB No. 25 and related interpretations as permitted by SFAS 123. Accordingly, no compensation expense was recognized for option grants in prior periods since the exercise price of options granted equaled the fair market value of the Company’s common stock on the date of grant. Stock-based compensation expense recorded in accordance with SFAS 123(R) decreased earnings for the years ended December 31, 2007 and 2006 by $338,000 and $238,000 respectively, net of tax benefit of $182,000 and $128,000, respectively.
No restatement of prior periods is required when SFAS 123(R) is adopted using the modified-prospective transaction method. SFAS 123(R) does, however, require disclosure of the effect that applying the fair value recognition provisions of SFAS 123 would have had on prior periods. The following table provides the required disclosure.
For 2005 disclosure purposes, the fair value of stock options was estimated at each date of grant using a Black-Scholes option pricing model using the following assumptions: Risk-free interest rates ranging from 3.5% to 6.1%; dividend yields ranging from 0.66% to 1.14%; volatility factors of the expected market price of the Company’s common stock ranging from .273 to .871; and a weighted average expected life of the options ranging from three to five years.
In management’s opinion, existing stock option valuation models do not provide an entirely reliable measure of the fair value of nontransferable employee stock options with vesting restrictions.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 10. EARNINGS PER SHARE OF COMMON STOCK
The following table sets forth the computation of basic and diluted earnings per share as of and for the years ended:
NOTE 11. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The unaudited quarterly results of operations for 2007 and 2006 are summarized as follows:
NOTE 12. BUSINESS SEGMENTS
The Company classifies its business into two segments: Direct Healthcare Liability Insurance and Assumed Reinsurance. Segments are designated based on the types of products provided and based on the risks associated with the products. Direct healthcare liability insurance represents professional liability insurance for physicians, oral and maxillofacial surgeons, and dentists, healthcare facilities and other healthcare providers. Assumed Reinsurance represents the book of assumed worldwide reinsurance of professional, commercial and personal liability coverages, commercial and residential property risks and accident and health, workers’ compensation and marine coverages. Other includes items not directly related to the operating segments such as net investment income, realized investment gains and losses, and other revenue.
The accounting policies of the segments are the same as those described in Note 1. The Company evaluates insurance segment performance based on the combined ratios of the segments. Intersegment transactions are not significant.
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following tables present information about reportable segment income (loss) and segment assets as of and for the periods indicated:
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SCPIE HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 13. COMPREHENSIVE INCOME
Comprehensive income is defined as all changes in Shareholders’ Equity except those arising from transactions with shareholders. Comprehensive income includes net income and other comprehensive income, which for the Company consists of changes in unrealized gains or losses on investment securities, and foreign currency and pension liabilities. With the adoption of SFAS 158, an adjustment to accumulated other comprehensive income was made to record gains or losses and prior service costs or credits for defined benefit and other postretirement benefit pension plans that had not yet been included in net periodic benefit cost.
Schedule II-Condensed Financial Information of Registrant
SCPIE HOLDINGS INC.
CONDENSED BALANCE SHEETS
(In Thousands, Except Share Data)
See accompanying notes to Condensed Financial Statements.
Schedule II-Condensed Financial Information of Registrant (continued)
SCPIE HOLDINGS INC.
CONDENSED STATEMENTS OF INCOME
(In Thousands)
See accompanying notes to Condensed Financial Statements.
Schedule II-Condensed Financial Information of Registrant (continued)
SCPIE HOLDINGS INC.
CONDENSED STATEMENTS OF CASH FLOWS
(In Thousands)
See accompanying notes to Condensed Financial Statements.
Schedule II-Condensed Financial Information of Registrant (continued)
SCPIE HOLDINGS INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
December 31, 2007
1. BASIS OF PRESENTATION
In the SCPIE Holdings Inc. condensed financial statements, investments in subsidiaries are stated at cost plus equity in undistributed earnings of subsidiaries since date of acquisition. The SCPIE Holdings Inc. condensed financial statements should be read in conjunction with its consolidated financial statements.
Schedule III-Supplementary Insurance Information
SCPIE Holdings Inc. and Subsidiaries
Year Ended December 31, 2007
(In Thousands)
Year Ended December 31, 2006
(In Thousands)
Year Ended December 31, 2005
(In Thousands)
(1)
Assumed reinsurance excludes amounts received under fronting arrangements.