Filed pursuant to Rule 424(b)(4)
Registration File No. 333-143241
PROSPECTUS
2,100,000 Shares
Common Stock
We are selling 2,000,000 shares of our common stock. The selling shareholder identified in this prospectus is selling an additional 100,000 shares. We will not receive any of the proceeds from the sale of shares being sold by the selling shareholder. Our common stock, including the offered shares, is traded on the Nasdaq Capital Market under the symbol AMPH.
On June 19, 2007, the reported last sale price of our common stock on the Nasdaq Capital Market was $17.00 per share.
You should consider the risks that we have described in Risk Factors beginning on page 10 before buying shares of our common stock.
Per Share | Total | |||||
Public offering price |
$ | 16.50 | $ | 34,650,000 | ||
Underwriting discounts and commissions |
$ | 0.99 | $ | 2,079,000 | ||
Proceeds, before expenses, to us |
$ | 15.51 | $ | 31,020,000 | ||
Proceeds, before expenses, to the selling shareholder |
$ | 15.51 | $ | 1,551,000 |
The underwriters may purchase up to an additional 315,000 shares from us at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover over-allotments.
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.
The underwriters expect to deliver the shares to purchasers on or before June 25, 2007.
RAYMOND JAMES | MORGAN KEEGAN & COMPANY, INC. |
The date of this prospectus is June 19, 2007
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Unaudited Pro Forma Condensed Consolidated Financial Information |
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Managements Discussion and Analysis of Financial Condition and Results of Operations |
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Material U.S. Federal Income Tax Consequences to Non-U.S. Holders |
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G-1 |
You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized anyone to provide you with additional information or information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of shares of our common stock. This prospectus contains terms that are specific to the insurance industry. A glossary of these terms appears beginning on page G-1 of this prospectus.
For investors outside of the United States: Neither we nor any of the underwriters have done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. You are required to inform yourselves about and to observe any restrictions relating to this offering and the distribution of this prospectus.
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This summary highlights certain information contained elsewhere in this prospectus. This summary does not contain all of the information you should consider before investing in our common stock. You should carefully read the entire prospectus, including Risk Factors and our financial statements and related notes, before you decide whether to invest in our common stock. References in this prospectus to our restated articles of incorporation and amended and restated bylaws refer to the articles of incorporation and bylaws as the same shall be in effect upon completion of this offering. If you invest in our common stock, you are assuming a degree of risk. See Risk Factors, beginning on page 10. References to we, our, our company, us or the Company refer to American Physicians Service Group, Inc.
Overview of Our Business
We are a leading provider of medical professional liability insurance in Texas, where our insurance subsidiary, American Physicians Insurance Company (API), has written business for over 30 years. Historically, we operated as the attorney-in-fact manager for API and, without the benefit of significant financial capital or a financial strength rating, grew API into a leading medical professional liability insurer in Texas. In April 2007, we acquired API, thus combining our insurance management expertise with an insurance underwriting entity to allow for expansion into new markets and continued growth in existing markets. API, together with our managing general agency subsidiary that manages API, comprise our Insurance Services business.
We believe APIs long-term presence in the Texas medical professional liability insurance market provides us with name recognition and strong relationships with the physicians practicing in Texas. The majority of our insurance business is distributed through independent agents, and we currently insure approximately 4,775 physicians, dentists and other healthcare providers. Over 99% of APIs premiums are written through purchasing groups, which in Texas currently subjects us to less stringent state regulation of premium rates and policy forms. We carefully review every new policy we issue and each policy considered for renewal. We meet regularly with an advisory board composed primarily of practicing physicians who advise us on underwriting and marketing practices as well as review our claims and claims management strategies.
We also offer brokerage and investment services to individuals and institutions, including general securities sales and trade execution, investment banking and asset management services. In this segment of our business, we focus on sectors of the fixed income market that we believe are underserved by larger financial services firms. This Financial Services segment of our business is conducted through APS Investment Services, Inc. and its subsidiaries.
Pro forma for our acquisition of API, as discussed below, our Insurance Services segment would have represented 82% of our total revenues in 2006.
Recent Acquisition of API
As part of our strategic goal of expanding our insurance operations, we acquired API on April 1, 2007. From 1975 until our acquisition of API, we managed all operations of API as its attorney-in-fact and API operated as a reciprocal insurance exchange with limited ability to raise capital to expand its operations. We considered many different factors and issues when examining the potential acquisition of API, including our enhanced interest in acquiring an insurance company given the favorable effects of tort reform in various markets, our long-term experience managing APIs operations, the common goals we shared with APIs board of directors, the ability to increase APIs capital to support future growth after the acquisition and the increased financial strength of the combined entity.
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In the late 1990s through most of 2003, the Texas medical professional liability insurance market suffered from high losses driven in part by large awards to claimants and a high frequency of claims. In response, Texas adopted tort reform legislation in September 2003, which limited the non-economic damages that can be awarded in many medical professional liability claims and improved the underwriting environment for medical professional liability insurers in the state. As a result of the benefits of tort reform and APIs commitment to sound underwriting practices, APIs net income grew from approximately $5.8 million in 2004 to approximately $15.8 million in 2006, and its equity grew from approximately $11.9 million to $34.7 million over the same period.
We acquired API by issuing approximately 2 million shares of common stock and approximately 10,198 shares of $1,000 per share redemption value preferred stock. We are required to redeem at least $1 million of the preferred stock each calendar year beginning in 2007, until December 31, 2016, at which time all of the preferred stock must have been redeemed. Our preferred stock has a cumulative dividend equal to 3% of the outstanding redemption value per year.
On a pro forma basis, if our acquisition of API had occurred on January 1, 2006, we would have recorded total revenue, net income and diluted earnings per share of $95.1 million, $18.3 million and $3.72, respectively in 2006 and $23.2 million, $2.3 million and $0.46, respectively for the three months ended March 31, 2007. Total revenue and pre-tax earnings from our insurance business would have accounted for approximately 82% and 93% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, in 2006 and approximately 79% and 88% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, for the first three months of 2007. See Unaudited Pro Forma Condensed Consolidated Financial Information, beginning on page 30.
Our Strengths
We believe that we are well positioned to capitalize on opportunities in our market as a result of the following competitive strengths:
| Long-standing Relationships with Physician Community. API was founded in 1975 by physicians to provide a stable source of medical professional liability insurance in the Texas market and, prior to our acquisition of API, it was governed by a board of directors primarily composed of practicing physicians. We believe that we have been able to retain this physician-driven insurance philosophy through the use of our advisory board, which is composed of former directors of API. Our advisory board meets regularly with API to consult on marketing, underwriting and claims strategy. We believe this active physician involvement is important to the physician community and gives us an advantage when marketing and servicing our policies and handling claims. Also, we believe our long-term presence in this market has established our reputation as a long-term, reliable source of medical professional liability insurance, which aids our efforts in attracting and retaining policyholders. |
| Innovation in Policy Design and Customization. We believe that our exclusive focus on medical professional liability insurance and our management teams expertise in this industry allow us to be innovative when customizing policy and coverage terms to meet the unique needs of our policyholders. We write substantially all of our policies on a claims-made basis, which generally shortens the time during which a policyholder may submit a claim under a policy. Through the extensive use of our management reporting technology and our 30-plus years of experience in identifying and meeting the needs of our policyholders, we are able to design new product offerings and modify our existing policy provisions to react to emerging trends and opportunities. We believe our policy innovation distinguishes us from our competition and allows us to write profitable business through many market cycles. |
| Pragmatic Approach to Claims Management. We aggressively defend against non-meritorious claims and strive to quickly resolve valid claims. Our claims department is staffed by personnel who average |
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over 14 years of experience in medical professional liability insurance claims. We meet monthly with members of our physician advisory board to assess current medical standards of care, claim status and various strategies of claim defense and resolution. We believe our approach to claims management helps us reduce the cost of claims made against our policyholders. |
| Comprehensive Customer Relationship Management. We maintain regular contact directly with our larger insurance customers and track the interaction we have with all of our policyholders to ensure that we maintain what we believe to be a strong and valued customer relationship. We visit the majority of our physician group clients on an annual basis in order to develop and maintain our relationship with their key insurance decision makers. We also solicit feedback from our insurance customers to help strengthen our customer relationships and improve the quality of our insurance services. We believe this level of customer relationship management, combined with a traditional agency distribution model, helps increase our retention rates in various market cycles and has helped us achieve recent retention rates of approximately 90%. |
| Value Added Loss Prevention Services. We provide our policyholders with a variety of risk management programs and resources designed to reduce the risk of professional liability claims being made against our insureds and to increase the defensibility in the event an insured is named in a medical professional liability claim. We believe our value added services help strengthen our customer relationships and further distinguish us from our competitors. |
| Experienced Management Team. Our senior management team averages over 22 years of experience in the financial services industry and 17 years with us (exclusive of our president and chief operating officer who joined us in April 2007 and who had been our external legal counsel for 14 years). The president, chief financial officer and vice president of claims of our insurance operations and our chairman and chief executive officer collectively have over 50 years of experience managing APIs operations as its attorney-in-fact prior to our acquisition of API. The president of our Financial Services operations has 22 years of experience in the investment and investment advisory industry. In addition, upon the closing of our acquisition of API, two physician members of the API board of directors were added to our board of directors. These physicians served on the board of directors of API prior to the acquisition for 31 and 29 years, respectively. We believe this experienced management team provides us with a competitive advantage and experience managing our operations through different market cycles. |
| Diverse Set of Products and Services Offered by Our Financial Services Business. Through our Financial Services operations, we provide a broad range of products and services including trade execution, fixed-income research, investment banking services, fixed-income asset management as well as trading and analysis of syndicated bank loans, trade claims and distressed private loan portfolios. We believe this broad product offering allows us to leverage trends in various segments of the financial services markets instead of relying on a single product or service for our operating results. |
Our Strategy
Our strategy is to utilize superior medical professional liability insurance underwriting and claims management expertise in new and existing markets and includes the following key elements:
| Prudently Grow our Existing Texas Insurance Business. While we currently write approximately 13% of the medical professional liability premiums in Texas, we believe that there are additional opportunities to expand in this market, through both internal growth initiatives and selective acquisitions. We believe that the strength of our underwriting, loss prevention, claims management and policyholder services will allow us to profitably increase our market share in Texas. We intend to leverage our quality service, experience, people and relationships to retain existing policyholders and expand in the Texas market. |
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| Conservatively Expand into New Markets. We intend to pursue profitable growth in new geographic markets, through both internal growth initiatives and selective acquisitions. We intend to focus on markets where we identify profitable underwriting opportunities and where we believe that we can hire or collaborate with qualified and experienced people to aid in our expansion efforts. Our expansion strategy will depend upon the competitive environment, the extent of tort reform in potential target markets, rate adequacy and our ability to collaborate with qualified local personnel experienced in the markets we choose to enter. |
| Focus on Underwriting Profitability. We are focused on maintaining adequate premium rate levels to allow for underwriting profitability. We intend to maintain our selective underwriting practices that involve careful review of every application we receive and a thorough review of every physician being considered for renewal. In addition, we will consider retaining a larger portion of the risks we cede to third-party reinsurers as we identify profitable opportunities to do so. |
| Obtain a Favorable Rating. Without the benefit of a financial strength rating, we established API as a leading medical professional liability insurer in Texas. We believe that a favorable financial strength rating will aid our future expansion efforts in new markets and support our growth in existing markets since many potential insurance customers require minimum financial strength ratings of their insurers. We intend to utilize a portion of the net proceeds from this offering to strengthen the capital of API and may pursue a favorable financial strength rating from A.M. Best or another qualified rating agency. |
| Maintain Profitability of Our Financial Services Operations. We intend to continue to generate favorable returns on invested capital in our Financial Services segment and build upon its track record of success. We believe that we can continue to increase the value of our investment banking and distressed debt trading operations through continued marketing and sales efforts. |
Recent Additions to our Management
In April 2007, Timothy L. LaFrey joined us in the position of president and chief operating officer of the Company and as a director. He is also a director and chief executive officer of API. He joined us to increase the depth of our management team as the Company capitalizes on its growth potential in light of the acquisition of API.
Upon the closing of our acquisition of API, Norris K. Knight, Jr., M.D. and William J. Peche, M.D. were added to our board of directors. Both had served on the board of directors of API prior to the acquisition.
Risks Affecting Us
| Geographic Concentration. Our written premiums are almost exclusively in Texas. Our revenues and profitability for the foreseeable future will be substantially impacted by prevailing regulatory, economic, demographic and competitive conditions in Texas. |
| Effective Pricing of Insurance Policies. If we fail to accurately assess the risks associated with the policyholders we insure, we may fail to establish appropriate premium rates, and our reserves for unpaid losses and loss adjustment expenses (which we refer to as loss and LAE reserves) may be inadequate to cover our actual losses. |
| Reliance on a Limited Group of Independent Agents. We distribute our insurance products through a limited group of independent agents, one of which represented 45% of our gross premiums and maintenance fees written in 2006. If our relationship with one or more of these agents changes or terminates, it could materially affect our revenues and results of operations. |
| Successful Challenges to Tort Reform. Texas enacted legislation in 2003 specifically directed at medical professional liability reform. This legislation includes limits on certain damages. |
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Tort reform may not be upheld by courts. In addition, if tort reform is effective, the business of providing professional and other liability insurance may become more attractive, causing an increase in competition. |
| Impact of Lock-up Agreements. A significant portion of our outstanding shares are subject to lock-up agreements, which, when they terminate, could result in a large number of our shares being sold, which could lower the market price at which our shares trade. |
| Potential Losses and Litigation Risk Associated with Our Financial Services Business. APS Capital Corp., one of our Financial Services subsidiaries, trades bank debt and trade claims, which subject us to potential losses and litigation risk. |
Corporate Information
We were organized in October 1974 under the laws of the State of Texas. Our principal executive office is at 1301 S. Capital of Texas Highway, Suite C-300, Austin, Texas 78746, and our telephone number is (512) 328-0888. Our website is www.amph.com. We make available free of charge on our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (the SEC).
A summary organizational chart showing our corporate structure is shown below:
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Common stock we are offering |
2,000,000 shares |
Common stock offered by the selling shareholder |
100,000 shares |
Common stock to be outstanding after this offering |
6,826,355 shares |
Over-allotment option |
We have granted the underwriters a 30-day option to purchase up to 315,000 additional common shares to cover over-allotments, if any. |
Use of proceeds |
We intend to use the net proceeds from this offering to implement our business strategy by (1) contributing approximately $10 million in capital to our insurance subsidiary in order to grow our current markets and prudently expand into new markets; and (2) using the balance of the net proceeds for general corporate purposes including possible acquisitions. See Use of Proceeds, beginning on page 24. |
Nasdaq Capital Market Symbol |
AMPH |
Unless otherwise indicated, the information in this prospectus is based on the number of shares outstanding as of April 30, 2007 and, unless otherwise indicated, excludes:
| exercise of the underwriters over-allotment option to purchase up to 315,000 additional shares of common stock in this offering; |
| 760,000 shares of common stock issuable upon exercise of options outstanding under our 1995 and 2005 Incentive and Non-Qualified Stock Option Plans, at a weighted average exercise price of $12.42 per share; and |
| 206,000 shares of common stock reserved for future grants under our 2005 Incentive and Non-Qualified Stock Option Plan and our Affiliated Group Deferred Compensation Master Plan (the Deferred Compensation Plan). |
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Summary Consolidated Historical Financial and Operating Data of American Physicians Service Group, Inc.
The following table sets forth selected historical financial and operating data for the Company. The income statement data set forth below for each of the years in the five-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006, 2005, 2004, 2003 and 2002 are derived from our audited consolidated financial statements included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto. The income statement data for the three months ended March 31, 2007 and 2006, and the balance sheet data as of March 31, 2007 and 2006, are derived from our unaudited consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of Statements of Financial Accounting Standards (SFAS) No. 123(R), Accounting for Stock-Based Compensation (SFAS No. 123(R)). All information is presented in accordance with accounting principles generally accepted in the United States of America (GAAP). Actual financial results through March 31, 2007 may not be indicative of future financial performance.
Equity compensation costs of approximately $1.2 million related to our acquisition of API are included in the three month period ended March 31, 2007.
Three Months Ended March 31, (unaudited) |
Year Ended December 31, | ||||||||||||||||||||||||||
2007 | 2006 | 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||||
(in thousands, except per share data) | |||||||||||||||||||||||||||
Selected Income Statement Data: |
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Revenues: |
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Insurance services |
$ | 3,657 | $ | 3,655 | $ | 15,555 | $ | 15,514 | $ | 15,316 | $ | 10,826 | $ | 9,454 | |||||||||||||
Financial services |
5,216 | 3,578 | 16,805 | 18,459 | 16,705 | 19,623 | 13,623 | ||||||||||||||||||||
Total revenues |
8,873 | 7,233 | 32,360 | 33,973 | 32,021 | 30,449 | 23,077 | ||||||||||||||||||||
Expenses: |
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Insurance services |
3,823 | 2,754 | 11,262 | 10,262 | 9,968 | 7,841 | 7,066 | ||||||||||||||||||||
Financial services |
4,437 | 3,285 | 15,145 | 16,263 | 14,538 | 16,584 | 11,876 | ||||||||||||||||||||
General and administrative |
777 | 518 | 2,128 | 2,737 | 2,227 | 2,069 | 1,951 | ||||||||||||||||||||
Gain on sale of assets |
(5 | ) | | (29 | ) | (134 | ) | (56 | ) | (8 | ) | (515 | ) | ||||||||||||||
Total expenses |
9,032 | 6,557 | 28,506 | 29,128 | 26,677 | 26,486 | 20,378 | ||||||||||||||||||||
Net income (loss) |
$ | (95 | ) | $ | 562 | $ | 3,194 | $ | 5,460 | $ | 2,152 | $ | 2,799 | $ | 3,411 | ||||||||||||
Per share amounts: |
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Basic: Net income (loss) |
$ | (0.03 | ) | $ | 0.20 | $ | 1.15 | $ | 2.03 | $ | 0.85 | $ | 1.27 | $ | 1.53 | ||||||||||||
Diluted: Net income (loss) |
$ | (0.03 | ) | $ | 0.19 | $ | 1.09 | $ | 1.86 | $ | 0.76 | $ | 1.14 | $ | 1.45 | ||||||||||||
Diluted weighted average shares outstanding |
2,822 | 2,909 | 2,933 | 2,931 | 2,838 | 2,449 | 2,345 | ||||||||||||||||||||
Cash dividends |
| | $ | 0.30 | $ | 0.25 | $ | 0.20 | | | |||||||||||||||||
Book value per share |
$ | 10.81 | $ | 10.16 | $ | 10.49 | $ | 9.95 | $ | 9.23 | $ | 7.78 | $ | 8.03 | |||||||||||||
Selected Balance Sheet Data: |
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Total assets |
$ | 41,606 | $ | 33,149 | $ | 36,276 | $ | 33,505 | $ | 30,443 | $ | 25,638 | $ | 24,981 | |||||||||||||
Long-term obligations |
| | | | 1,133 | 1,576 | 2,665 | ||||||||||||||||||||
Total liabilities |
10,668 | 5,147 | 6,687 | 5,783 | 6,229 | 6,532 | 7,455 | ||||||||||||||||||||
Minority interests |
21 | 16 | 21 | 15 | 1 | | 384 | ||||||||||||||||||||
Total shareholders equity |
$ | 30,917 | $ | 27,986 | $ | 29,568 | $ | 27,707 | $ | 24,213 | $ | 19,106 | $ | 17,142 |
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Summary Historical Financial and Operating Data of American Physicians Insurance Company
The following table sets forth selected historical financial and operating data for API. The income statement data for each of the years in the three-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006 and 2005 are derived from the audited financial statements of API included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto. The income statement data for the year ended December 31, 2003 and the balance sheet data for the year ended December 31, 2004 are derived from the audited financial statements of API. The income statement data for the year ended December 31, 2002 and for the three months ended March 31, 2007 and 2006, and the balance sheet data as of December 31, 2003 and 2002 and March 31, 2007 and 2006, are derived from unaudited financial statements of API which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods and all adjustments are normal recurring in nature. All selected data are presented in accordance with GAAP.
Three Months Ended March 31, |
Year Ended December 31, | |||||||||||||||||||||||||||
2007 | 2006 | 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||
Income Statement Data: |
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Gross premiums and maintenance fees writtendirect and assumed |
$ | 15,466 | $ | 20,115 | $ | 74,833 | $ | 79,301 | $ | 84,571 | $ | 70,993 | $ | 58,815 | ||||||||||||||
Premiums ceded |
(2,407 | ) | (2,777 | ) | (4,709 | ) | (12,885 | ) | (12,878 | ) | (10,352 | ) | (7,596 | ) | ||||||||||||||
Net premiums and maintenance fees written |
13,059 | 17,338 | 70,124 | 66,416 | 71,693 | 60,641 | 51,219 | |||||||||||||||||||||
Net premiums and maintenance fees earned |
16,311 | 17,631 | 70,859 | 64,183 | 64,616 | 52,844 | 38,168 | |||||||||||||||||||||
Investment income, net of investment expenses |
1,791 | 1,451 | 6,466 | 5,131 | 4,089 | 3,119 | 3,300 | |||||||||||||||||||||
Realized capital gains (losses)net |
126 | 102 | 6 | 552 | 608 | 185 | (214 | ) | ||||||||||||||||||||
Total revenues |
18,228 | 19,184 | 77,331 | 69,866 | 69,313 | 56,148 | 41,254 | |||||||||||||||||||||
Losses and loss adjustment expenses |
10,934 | 12,153 | 38,970 | 43,976 | 48,655 | 44,546 | 29,616 | |||||||||||||||||||||
Other underwriting expenses and net change in deferred acquisition costs |
3,355 | 3,168 | 14,213 | 12,671 | 11,422 | 9,699 | 10,213 | |||||||||||||||||||||
Total expenses |
14,289 | 15,321 | 53,183 | 56,647 | 60,077 | 54,245 | 39,829 | |||||||||||||||||||||
Income from Operations |
3,939 | 3,863 | 24,148 | 13,219 | 9,236 | 1,903 | 1,425 | |||||||||||||||||||||
Federal income tax expense (benefit) |
1,326 | 1,445 | 8,397 | 4,188 | 3,421 | 1,211 | (116 | ) | ||||||||||||||||||||
Net income |
$ | 2,613 | $ | 2,418 | $ | 15,751 | $ | 9,031 | $ | 5,815 | $ | 692 | $ | 1,541 | ||||||||||||||
GAAP Underwriting Ratios: |
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Loss ratio (1) |
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Current accident year |
67% | 66% | 61% | 44% | 45% | 64% | 60% | |||||||||||||||||||||
Prior years |
0% | 3% | -6% | 25% | 30% | 20% | 17% | |||||||||||||||||||||
Calendar year |
67% | 69% | 55% | 69% | 75% | 84% | 77% | |||||||||||||||||||||
Expense ratio (2) |
21% | 18% | 20% | 19% | 18% | 18% | 27% | |||||||||||||||||||||
Combined ratio (3) |
88% | 87% | 75% | 88% | 93% | 102% | 104% | |||||||||||||||||||||
Balance Sheet Data: |
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Cash and cash equivalents and investments |
$ | 163,457 | $ | 125,702 | $ | 144,583 | $ | 116,749 | $ | 106,457 | $ | 85,671 | $ | 68,582 | ||||||||||||||
Premiums and maintenance fees receivable |
14,647 | 14,427 | 16,493 | 13,703 | 14,971 | 10,354 | 8,294 | |||||||||||||||||||||
Reinsurance recoverables |
31,058 | 34,220 | 37,217 | 34,653 | 16,162 | 18,321 | 19,656 | |||||||||||||||||||||
All other assets |
9,179 | 8,646 | 8,025 | 9,728 | 8,138 | 9,174 | 5,907 | |||||||||||||||||||||
Total Assets |
218,341 | 182,995 | 206,318 | 174,833 | 145,728 | 123,520 | 102,439 | |||||||||||||||||||||
Reserve for losses and loss adjustment expenses |
116,227 | 103,275 | 110,089 | 95,372 | 69,445 | 63,713 | 54,187 | |||||||||||||||||||||
Unearned premiums and maintenance fees |
36,516 | 40,303 | 39,786 | 40,698 | 38,346 | 31,035 | 23,223 | |||||||||||||||||||||
Refundable subscriber deposits |
10,198 | 10,457 | 10,227 | 10,568 | 11,001 | 11,461 | 11,578 | |||||||||||||||||||||
All other liabilities |
18,135 | 8,369 | 11,498 | 8,953 | 15,035 | 11,407 | 8,279 | |||||||||||||||||||||
Total Liabilities |
181,076 | 162,404 | 171,600 | 155,591 | 133,827 | 117,616 | 97,267 | |||||||||||||||||||||
Total Members Equity |
$ | 37,265 | $ | 20,591 | $ | 34,718 | $ | 19,242 | $ | 11,901 | $ | 5,904 | $ | 5,172 |
(1) | Loss ratio is defined as the ratio of losses and loss adjustment expenses to net premiums and maintenance fees earned. |
(2) | Expense ratio is defined as the ratio of other underwriting expenses and net change in deferred acquisition costs to net premiums and maintenance fees earned. |
(3) | Combined ratio is the sum of the loss ratio and the expense ratio. |
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Summary Unaudited Pro Forma Financial Information
The following selected unaudited pro forma consolidated financial data has been derived from and should be read in conjunction with the unaudited pro forma condensed consolidated financial statements included elsewhere herein and related notes thereto. This information is based on the historical unaudited consolidated balance sheets as of March 31, 2007 and the consolidated unaudited statements of income of the Company and API for the three months ended March 31, 2007 and the audited statements of income of the Company and API for the year ended December 31, 2006. The statements include pro forma adjustments as described in the notes accompanying the financial statements.
The unaudited pro forma condensed consolidated financial information does not purport to represent what our results of operations or financial condition would have been had the transactions noted above actually occurred on the dates specified, nor does it purport to project our results of operations or financial condition for any future period or as of any future date. The unaudited pro forma condensed consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition.
Equity compensation costs of approximately $1.2 million related to our acquisition of API are included in the three month period ended March 31, 2007.
The unaudited pro forma condensed consolidated balance sheet as of the period ended March 31, 2007 is presented as if the API acquisition occurred on March 31, 2007. The unaudited pro forma condensed consolidated statements of operations for the year ended December 31, 2006 and the three months ended March 31, 2007 and March 31, 2006 are presented as if the API acquisition occurred on January 1, 2006. See Unaudited Pro Forma Condensed Consolidated Financial Information, beginning on page 30.
Three Months Ended March 31, |
Year Ended December 31, | |||||||||||
2007 | 2006 | 2006 | 2005 | |||||||||
(in thousands, except per share data) | ||||||||||||
Pro Forma Income Statement Data: |
||||||||||||
Net premiums and maintenance fees earned |
$ | 16,311 | $ | 17,631 | $ | 70,859 | $ | 64,183 | ||||
Investment income, net of investment expenses |
2,119 | 1,682 | 7,635 | 5,832 | ||||||||
Financial services revenues |
4,910 | 3,457 | 16,050 | 18,459 | ||||||||
Total revenues |
23,165 | 22,980 | 95,139 | 92,595 | ||||||||
Net income |
2,258 | 3,544 | 18,274 | 14,212 | ||||||||
Net income per share |
||||||||||||
Basic |
0.47 | 0.75 | 3.84 | 3.04 | ||||||||
Diluted |
0.46 | 0.72 | 3.72 | 2.89 | ||||||||
As of March 31, 2007 |
||||||||||||
(in thousands, except per share data) |
||||||||||||
Pro Forma Balance Sheet Data: |
||||||||||||
Investments |
$ | 175,489 | ||||||||||
Total assets |
255,413 | |||||||||||
Reserve for losses and loss adjustment expenses |
116,227 | |||||||||||
Total liabilities |
189,581 | |||||||||||
Minority interests |
21 | |||||||||||
Shareholders equity |
65,811 | |||||||||||
Book value per share |
13.59 |
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Investing in our common stock involves a high degree of risk. You should carefully consider the following risks and all other information contained in this prospectus before purchasing our common stock. Our business, financial condition or results of operations could be materially and adversely affected by any of these risks. The trading price of our common stock could decline due to any of these risks and you may lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS AND OUR INDUSTRY
Our geographic concentration means that our insurance business performance may be affected by economic, regulatory and demographic conditions of our operations within the State of Texas.
Our business is concentrated in Texas, in which we generated 99% of our premiums written for each of the three months ended March 31, 2007 and the year ended December 31, 2006. Accordingly, unfavorable economic, regulatory and demographic conditions in Texas would negatively impact our business. We focus exclusively on medical professional liability insurance. In the event there is meaningful change in the existing legislation and claims environment, our financial condition and results of operations could be adversely affected. We may be exposed to greater risks than those faced by insurance companies that conduct business over a larger geographic area. For example, our geographic concentration could subject us to pricing pressure as a result of market or regulatory forces.
Our Insurance Services subsidiaries operate in highly competitive businesses against competitors with greater financial, marketing, technological and other resources.
The insurance industry is highly competitive. Many of our competitors possess greater financial, marketing, technological and other resources. We may not be able to continue to compete successfully.
All of our revenue from the Insurance Services segment is attributable to API. API competes with several insurance carriers, including Medical Protective Insurance Services Inc., Texas Medical Liability Trust (TMLT), ProAssurance Corporation, The Doctors Company, Advocate MD RPG, Inc., the Texas Medical Liability Insurance Underwriting Association, which is the state-sponsored insurer of last resort, and Medicus Insurance Company. We consider these companies APIs competitors because they are the companies to which policyholders who cancel their policies with API typically move. Many of our competitors have greater financial strength and broader resources than us. We compete with these companies on a variety of factors including price, customer service, expertise in claims handling, policy coverage, risk management services and financial strength. In premiums written and asset size, Medical Protective Insurance Services Inc., TMLT, ProAssurance Corporation and The Doctors Company are significantly larger than API, and Advocate MD RPG, Inc. and Medicus Insurance Company are smaller than API. Texas Medical Liability Insurance Underwriting Association is larger than API in terms of asset size and smaller than API in terms of annualized earned premiums. We do not have the capacity to write the volume of business equal to that of some of the other major carriers. With the implementation of tort reform in late 2003, additional companies have re-entered, and other national companies may re-enter, the Texas market, resulting in further increases in competition. As a result of this increased competition, API continues to face price pressure on both existing renewals and new business.
Our largest insurance competitor, TMLT was established under the provisions of a statute that authorized a statewide association of physicians or dentists to create a trust to self-insure its members. By statute, only members of the founding association may obtain insurance from TMLT. TMLT is subject to limited government regulation in comparison to other insurance companies, such as API, in regards to statutory financial reporting and financial examinations by the Texas Department of Insurance. TMLT further benefits from a low-cost structure as it is not required to pay premium taxes and does not participate in the guaranty association. As a result, we are at a competitive disadvantage in competing against TMLT.
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Our reliance on key executives could affect our results of operations.
We believe that our success depends on the efforts and abilities of a relatively small group of our executive personnel. The loss of services of one or more of these key executives could have a material adverse effect on our business. We do not maintain key man life insurance on any of our key executives. We have identified our key executives as: Kenneth S. Shifrin, chairman of the board and chief executive officer; Timothy LaFrey, president and chief operating officer; George Conwill, president of APS Investment Services; Maury Magids, president of APS Insurance Services, Inc.; and William Hayes, chief financial officer. In 2000, Mr. Shifrin was diagnosed with chronic lymphocytic leukemia. We anticipate that the treatments Mr. Shifrin is taking for this condition in 2007 may have an impact on the amount of time he will be able to devote to our business and that worsening of the effects of this condition could further reduce our access to Mr. Shifrins services, which could adversely affect our business.
If we do not effectively price our insurance policies, then our financial results will be adversely affected.
Our premium rates are established when coverage is initiated and based on factors that include estimates of expected losses generated from the policies we underwrite. We analyze many factors when pricing a policy, including the policyholders prior loss history, medical specialty and practicing territory. If we underprice our insurance policies, actual costs for providing insurance coverage to policyholders may be significantly higher than associated premiums. When initiating coverage on a policyholder, we must rely on information provided by the policyholder or previous carriers to properly estimate future claims exposure. If any information is inaccurate, we could underprice our policies by using claims estimates that are too low. As a result, actual costs for providing insurance coverage to policyholders may be significantly higher than associated premiums. We assume the risk that policies in force were written at inadequate premium rates.
If our relationships with certain of our independent agencies, one of which accounts for a significant part of our business, were terminated, our financial condition and results of operations could be materially adversely affected.
We market and sell our insurance products through a group of approximately 22 active independent, non-exclusive insurance agents. In addition, for the year ended December 31, 2006, approximately 45% of our gross premiums written were produced by one agency. This agency also serves as APIs primary reinsurance broker.
We do not have exclusive arrangements with our agents, and either party can terminate the relationship at any time. These agents are not obligated to promote our products and also sell our competitors products. We must offer medical professional liability insurance products and services that meet the requirements of these agents and their customers. We must also provide competitive commissions to these agents.
Thus, our relationships with our distribution partners may not continue or may continue under terms that are not as favorable to us as our current agreements. Also, if we do not maintain good relationships with the agents with which we contract to sell our products, these agents may sell our competitors products instead of ours or may direct less desirable risks to us, and our revenues or profitability may decline. In addition, these agents may find it easier to promote the broader range of programs of some of our competitors than to promote our single-line medical professional liability insurance products. The loss of a number of our independent agents or the failure of these agents to successfully market our products could result in lower gross premiums written and have a material adverse effect on our financial condition and results of operations if we are unable to replace them with agents that produce comparable premiums.
Loss reserves in our Insurance Services business are based on estimates and may be inadequate to cover actual loss and loss adjustment expenses.
As a risk-bearing insurance entity, we must establish and maintain reserves for our estimated liability for losses and loss adjustment expenses in our Insurance Services business. We establish loss reserves in our
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financial statements that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have not yet been reported to us. Loss reserves are estimates of the ultimate cost of individual claims based on actuarial estimation techniques and are inherently uncertain. Judgment is required in applying actuarial techniques to determine the relevance of historical payment and claim closure patterns under current facts and circumstances. We periodically review our established reserves and may adjust reserves based on the results of these reviews. If we change our estimates, these changes are reflected in results of operations during the period in which they are made. These adjustments could be significant.
As a holding company, our financial condition and results of operations are dependent on our subsidiaries and our ability to pay expenses and dividends will be dependent on our ability to receive dividends from our subsidiaries, which may be restricted.
We are principally a holding company with assets consisting primarily of cash, investment securities and the capital stock of our subsidiaries. Consequently, our ability to pay our operating expenses, make redemption payments on our Series A redeemable preferred stock and service our other indebtedness is dependent upon the earnings of our subsidiaries and our ability to receive funds from such subsidiaries through loans, dividends or otherwise. Our subsidiaries are legally distinct entities and have no obligation, contingent or otherwise, to make funds available to us for such obligations. In addition, our subsidiaries ability to make such payments is subject to applicable state laws and claims of our subsidiaries creditors will generally have priority as to the assets of such subsidiaries. Accordingly, our subsidiaries may not be able to pay funds to us sufficient to enable us to meet our obligations. The ability of API to pay dividends to us or redeem any of the API preferred stock that we hold is subject to regulation by the Texas Department of Insurance. In addition to restrictions on dividends and distributions applicable to all Texas stock insurance companies, for so long as any Series A redeemable preferred stock is outstanding, the Texas Department of Insurance prohibits API from paying dividends to us on the API common stock that we hold in any fiscal year unless and until we comply with our redemption and dividend payment obligation to the holders of our Series A redeemable preferred stock for that year. We have also agreed that, without prior approval of the Texas Department of Insurance, aggregate annual dividends on API common stock and payments made to redeem API preferred stock held by us may not exceed the lesser of 10% of APIs prior year-end policyholder statutory earned surplus or APIs prior year net income, and in no event may exceed APIs policyholder statutory earned surplus. By way of illustration, if this dividend and redemption restriction had been in place in 2004, 2005 and 2006, possible dividends paid by API to us for those years would have been limited to $357,268, $870,465 and $1,555,400, respectively. Accordingly, our subsidiaries may not be able to pay funds to us and, even if paid such funds may not be sufficient to enable us to meet our obligations.
If tort reform is successfully challenged, it could materially affect our insurance operations.
Tort reforms generally restrict the ability of a plaintiff to recover damages by imposing one or more limitations, including, among other limitations, eliminating certain claims that may be heard in a court, limiting the amount or types of damages, changing statutes of limitation or the period of time to make a claim and/or limiting venue or court selection. Texas enacted legislation in 2003 specifically directed at medical professional liability reform. Among the more significant aspects of the legislation were caps on non-economic damages and caps on non-economic damages against a single institution and against all healthcare institutions combined.
While the effects of tort reform may be generally beneficial to our insurance business, such reforms may not be effective or ultimately upheld by the courts. In the event that we begin experiencing an increase in claims frequency and/or severity, we will have to respond with corresponding increases to premium rate levels. These changes in rates may prevent us from having the ability to expand our Insurance Services business in the Texas marketplace. In addition, the benefits of tort reform may be accompanied by regulatory actions by state insurance authorities that may be detrimental to our insurance business, such as expanded coverage requirements and premium rate limitations or rollbacks.
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Prior-year favorable experiences on our variable premium reinsurance contracts may not continue to result in favorable adjustments to ceded premiums.
Our reinsurance contracts for 2002 through 2007 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contract is subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
For the year ended December 31, 2006, API recorded favorable net development to ceded premiums of $7,743,000 related to prior variable premium reinsurance treaties as a result of lower estimated loss and loss adjustment expenses for treaty years 2002 through 2005. Prior-year favorable experiences on our variable premium reinsurance contracts may not continue to result in favorable adjustments to ceded premiums.
Our Financial Services subsidiaries operate in highly competitive businesses against competitors with greater financial, marketing, technological and other resources.
Our Financial Services businesses are engaged in a highly competitive industry. We compete with numerous other broker-dealers, many of which are well known national or large regional firms with substantially greater financial and personnel resources. We also compete with a number of smaller regional brokerage firms in Texas and the southwestern United States.
In many instances APS Financial Corporation (APS Financial), our broker-dealer subsidiary, competes directly with these organizations. In addition, there is competition for investment funds from the real estate, insurance, banking and thrift industries. APS Financial competes for brokerage transactions principally on the basis of our research, our reputation in particular markets, and the strength of our client relationships. In our investment banking activities, we compete with large, well-known investment banks as well as regional service providers who offer placement and advisory services to small-and middle market companies. We compete for these investment banking assignments on the basis of our relationships with the issuers, potential investors, industry experience and transactional fees.
There is also significant competition in the financial services industry for qualified employees. We compete with other securities firms for investment bankers, sales representatives, securities traders, analysts and other professionals. Our ability to compete effectively depends on our ability to attract, retain and motivate qualified employees.
Our Financial Services businesses are subject to market forces beyond our control, which could affect us more severely than our competitors.
Our Financial Services businesses, like other securities firms, are directly affected by economic and political conditions, broad trends in business and finance and changes in volume and price levels of securities transactions. In recent years, the U.S. securities markets have experienced significant volatility. If our trading volume decreases, our revenues decline. Also, when trading volume is low, our profitability is adversely affected because our overhead remains relatively fixed, despite lower compensation costs associated with commission revenues. Severe market fluctuations in the future could have a material adverse effect on our business, financial condition and operating results. Certain of our competitors with more diverse product and service offerings might withstand such a downturn in the securities industry better than we would.
Our Financial Services segment is dependent on a limited number of customers and the loss of one or more of these customers could adversely affect our profitability.
We receive a substantial portion of our Financial Services revenues from a limited number of customers. In 2006, one customer and its related entities comprised approximately 44% of our total Financial Services
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revenues. The loss of this customer could significantly negatively affect the operating results of our Financial Services segment.
Market conditions could cause reinsurance to be more costly or unavailable for our Insurance Services business.
As part of our overall risk management strategy, we currently purchase reinsurance for amounts of risk from $250,000 up to $1,000,000. If we are unable to maintain our current reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates, or if we are unable to renew our expiring reinsurance coverage, we may be adversely affected by losses or have to reduce the amount of risk we underwrite.
We bear credit risk with respect to our reinsurers, and if any reinsurer fails to pay us, or fails to pay us on a timely basis, we could experience a shortage of liquidity or unexpected losses.
We transfer some of our risks to reinsurance companies in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, it does not relieve us of our liability to our policyholders. If reinsurers fail to pay us or fail to pay on a timely basis, our financial results will be adversely affected. At March 31, 2007, API had reinsurance recoverables on paid and unpaid losses and loss adjustment expenses of approximately $29,685,000.
Until we acquired API, it operated as a reciprocal insurance exchange that provided insurance to its subscribers, and therefore its historical financial and business results may not be representative of future results.
Prior to April 1, 2007, API was a reciprocal insurance exchange, with a business goal to provide a stable source of medical professional liability insurance in Texas. Our business goal is to maximize APIs long-term profitability. This change in business goals may not be successful, which could result in our income being significantly reduced. In addition, we are subject to risks associated with negative customer perception of a for-profit corporation, as compared to a reciprocal insurance exchange, which may cause significant customer defections and a loss in market share.
If we are unable to obtain and maintain a favorable financial strength rating, it may be more difficult for our Insurance Services business to write new business or renew its existing business.
Third party rating agencies assess and rate the claims-paying ability of insurers based upon criteria established by the agencies. The financial strength ratings assigned by rating agencies to insurance companies represent independent opinions of financial strength and ability to meet policyholder obligations and are not directed toward the protection of investors. These ratings are not recommendations to buy, sell or hold any security.
Financial strength ratings are used by agents and clients as an important means of assessing the financial strength and quality of insurers. API has no financial strength rating. The inability of API to obtain a favorable rating within a reasonable period of time could adversely affect its ability to sell insurance policies and inhibit API from competing effectively. If market conditions for APIs insurance become more competitive, competitors with higher financial strength ratings might have a competitive advantage. These results could have a material adverse effect on our results of operations and financial condition.
Our Insurance Services business is subject to extensive government regulation.
Insurance businesses are subject to extensive regulation by state insurance authorities in each state in which they operate. Regulation is intended for the benefit of policyholders rather than shareholders. In addition to
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control over the amount of dividends and other payments that can be made by API, these regulatory authorities have broad administrative and supervisory power relating to licensing requirements, trade practices, capital and surplus requirements, investment practices and rates charged to insurance customers.
These regulations may impede or impose burdensome conditions on rate increases or other actions that we may want to take to enhance our operating results. In addition, we incur significant costs in the course of complying with regulatory requirements. Also, our ability to grow API through premiums and additional capacity could be limited due to surplus and risk-based capital requirements under the financial regulatory guidelines of the Texas Department of Insurance.
The National Association of Insurance Commissioners (NAIC) Insurance Regulatory Information System (IRIS) was developed to help state regulators identify companies that may require special attention. IRIS identifies key financial ratios and specifies usual ranges for each ratio. Departures from the usual ranges of ratios may lead to inquiries from the insurance regulators. In 2006, API had three values outside the normal range, two related to the growth of its surplus and one related to the increase in prior year loss reserves.
Most states also regulate insurance holding companies like us in a variety of matters, such as restrictions on acquisitions, changes of control and the terms of affiliated transactions.
Currently, pursuant to an order of the Texas Department of Insurance, we must redeem at least $1 million of our Series A redeemable preferred stock each calendar year beginning in 2007, until December 31, 2016, at which time all of the Series A redeemable preferred stock must have been redeemed. We also must pay a cumulative dividend equal to holders of our Series A redeemable preferred stock equal to 3% of the outstanding redemption value per year. In addition, the Texas Department of Insurance has required us to place $2.5 million into an escrow account with a bank, to remain in escrow until the aggregate remaining redemption and dividend obligation with respect to our Series A redeemable preferred stock is less than the amount of such escrow balance. We have agreed that no withdrawals will be made from this escrow account without prior approval from the Texas Department of Insurance.
Further, the NAIC and certain state insurance regulators are re-examining current laws and regulations, specifically focusing on issues relating to the solvency of insurance companies, interpretations of existing laws and the development of new laws. Although the federal government does not directly regulate the business of insurance, federal initiatives often affect the insurance industry in a variety of ways. The effects of any future legislative or regulatory changes may have a material adverse effect on our Insurance Services business.
Our Financial Services business is subject to extensive government regulation.
The securities industry is subject to extensive governmental supervision, regulation and control by the SEC, state securities commissions and self-regulatory organizations, which may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of APS Financial or any of its officers or employees. The NASD regulates our Financial Services business marketing activities. The NASD can impose certain penalties for violations of its advertising regulations, including censures or fines, suspension of all advertising, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer or any of its officers or employees.
Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of a system to ensure compliance with these laws and rules, as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions due to claimed noncompliance in the future, which could have a material adverse effect on our business, financial condition and operating results.
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The federal or state governments or self-regulatory organizations having jurisdiction over our insurance and securities businesses could adopt regulations or take other actions, such as the failure to renew or the revocation of required licenses and certifications that would have a material adverse effect on our business, financial condition and results of operations. In addition, our operations and profitability may be affected by additional legislation, changes in rules promulgated by the SEC, NASD, the Board of Governors of the Federal Reserve System, the various stock exchanges and other self-regulatory organizations and state securities commissions or changes in the interpretation or enforcement of existing laws or rules.
Our Financial Services business must maintain certain net capital requirements that could slow our expansion plans or prevent payments of dividends.
The SEC, NASD and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the SEC and suspension or expulsion by the NASD and could ultimately lead to the firms liquidation. If such net capital rules are changed or expanded or if there is an unusually large charge against net capital, operations that require the intensive use of capital would be limited. Such operations may include trading activities and the financing of customer account balances. Also, our ability to pay dividends, repay debt and redeem or purchase shares of our outstanding stock could be severely restricted. A significant operating loss or an extraordinary charge against net capital could adversely affect the ability of APS Financial to expand or even maintain its present levels of business, which could have a material adverse effect on our business, financial condition and operating results.
Failure of third-party vendors to provide critical services could harm our business.
We rely on a number of third parties to assist in the processing of our transactions, including online and internet service providers, back-office processing organizations, and market makers. In particular, we clear all of our trades from our broker-dealer through one clearing firm, Southwest Securities, Inc. We do not control the actions of these third-party vendors. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could have a material adverse effect on our business, financial condition and operating results.
The fact that we write only a single line of insurance may leave us at a competitive disadvantage and subjects our financial condition and results of operations to the cyclical nature of the medical professional liability insurance market.
We face a competitive disadvantage because we only offer a single line of insurance. Some of our competitors have additional competitive leverage because of the wide array of insurance products that they offer. For example, a business may find it more efficient or less expensive to purchase multiple lines of insurance coverage from a single carrier. Because we do not offer a range of insurance products and sell only medical professional liability insurance, we may lose potential customers to larger competitors who do offer a selection of insurance products.
Growth in premiums written in the medical professional liability insurance industry have fluctuated significantly over the past ten years as a result of, among other factors, changing premium rates. The cyclical pattern of such fluctuation has been generally consistent with similar patterns for the broader property and casualty insurance industry, due in part to the participation in the medical professional liability insurance industry of insurers and reinsurers that also participate in many other lines of property and casualty insurance and reinsurance. Historically, the financial performance of the property and casualty insurance industry has tended to fluctuate in cyclical patterns characterized by periods of greater competition in pricing and underwriting terms and conditions, otherwise referred to as a soft insurance market, followed by periods of capital shortage, lesser competition and increasing premium rates, otherwise referred to as a hard insurance market.
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For the past two years, the medical professional liability insurance industry has faced a soft insurance market that has generally resulted in lower premium rates. During this two-year period, our rates have decreased by approximately 13% per year on average. We cannot predict whether, or the extent to which, the recent decreases in premium rates will continue.
Changes in the healthcare industry could have a material impact on the results of operations of our Insurance Services business.
Our Insurance Services business derives substantially all of its medical professional liability insurance premiums from physicians and other individual healthcare providers, physician groups and smaller healthcare facilities. Significant attention has recently been focused on reforming the healthcare industry at both the federal and state levels. In recent years, a number of factors related to the emergence of managed care have negatively affected or threatened to affect the practice of medicine and economic independence of medical professionals. Medical professionals have found it more difficult to conduct a traditional fee-for-service practice and many have been driven to join or contractually affiliate with provider-supported organizations. Such change and consolidation may result in the elimination of, or a significant decrease in, the role of the physician in the medical professional liability insurance purchasing decision and could reduce our medical professional liability insurance premiums, as groups of insurance purchasers may be able to retain more risk.
If we are unable to successfully write policies in new states, we may not be able to grow and our financial condition and results of operations could be adversely affected.
One of our strategies is to write medical professional liability insurance in new states, either through internal growth initiatives or selective acquisitions. However, our lack of experience in these new states means that this strategy is subject to various risks, including risks associated with our ability to:
| comply with applicable laws and regulations in those new states; |
| obtain accurate data relating to the medical professional liability industry and competitive environment in those new states; |
| attract and retain qualified personnel for expanded operations; |
| identify and attract acquisition targets; |
| identify, recruit and integrate new independent agents; |
| augment our internal monitoring and control systems as we expand our business; and |
| integrate an acquired business into our operations. |
Any of these risks, as well as risks that are currently unknown to us or adverse developments in the regulatory or market conditions in any of the new states that we enter, could cause us to fail to grow and could adversely affect our financial condition and results of operations.
The unpredictability of court decisions could have a material impact on our results of operations.
Our results of operations may be adversely affected by court decisions that expand the liability on the insurance policies API issues after they have been issued and priced. Additionally, a significant jury award, or series of awards, against one or more of APIs insureds could require API to pay large sums of money in excess of its reserved amounts. APIs policy to aggressively litigate claims against its insureds that it considers unwarranted or claims where settlement resolution cannot be achieved may increase the risk that API may be required to make such payments.
API could become subject to claims for extra-contractual obligations or losses in excess of policy limits in connection with its policyholders insurance claims. These claims are sometimes referred to as bad faith actions as it is alleged that the insurance company failed to negotiate a settlement of a claim in good faith within
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the insureds policy limit. API currently maintains insurance in the form of a component of its ceded reinsurance for such occurrences, which serves to mitigate exposure to such claims. However, the assertion of multiple claims for extra-contractual obligations in a single year or one or more large claims in a single year could result in potential exposure materially in excess of insurance coverage or in increased costs of such insurance coverage. Such occurrences could have a material adverse effect on our results of operations and financial condition.
We are exposed to interest rate and investment risk.
Changes in interest rates could have an impact at our broker-dealer subsidiary, APS Financial. As interest rates increase, bond prices typically decrease and vice-versa. Since revenues at APS Financial are primarily recorded as commissions earned on the trading of fixed-income securities, a rise in interest rates would cause a drop in the yield of these securities and would generally result in customers being cautious about committing funds or selling their positions, thus negatively affecting commissions earned. The general level of interest rates may trend higher or lower in 2007, and this move may impact our level of business in different fixed-income sectors. A volatile interest rate environment in 2007 could also impact our business as this type of market condition can lead to investor uncertainty and their corresponding willingness to commit funds. If a generally improving economy is the impetus behind higher rates, our investment grade business may decline.
A material decline, other than temporary, in the value of any of our debt or equity securities could have a material adverse effect on our financial condition and results of operations. A decline in the value of equity securities, evidenced by lower prices traded for the common stock of these companies, might occur for several reasons, including poor financial performance, obsolescence of the service or product provided or any other news deemed to be negative by the investing public. A decline in the value of debt securities might occur for the same reasons above as well as due to an increase in interest rates.
If we cannot obtain adequate or additional capital on favorable terms, we may not have sufficient funds to implement our future growth or operating plans and our business, financial condition or results of operations could be materially adversely affected.
If we have to raise additional capital, equity or debt financing may not be available on terms that are favorable to us. In the case of equity financings, dilution to our shareholders could result. In any case, such securities may have rights, preferences and privileges that are senior to those of our shares of common stock. In the case of debt financings, we may be subject to covenants that restrict our ability to freely operate our business. If we cannot obtain adequate capital on favorable terms or at all, we may not have sufficient funds to implement our future growth or operating plans and our business, financial condition or results of operations could be materially adversely affected.
Customers of our Financial Services business may default on their margin accounts, effectively passing their losses on to us.
Our Financial Services customers sometimes purchase securities on margin through our clearing organization, Southwest Securities, Inc.; therefore, we are subject to risks inherent in extending credit. This risk is especially great when the market is rapidly declining. In such a decline, the value of the collateral securing the margin loans could fall below the amount of a customers indebtedness. Specific regulatory guidelines mandate the amount that can be loaned against various security types. Independent of our review, our corresponding clearing organization independently maintains a credit review of our customer accounts. If customers fail to honor their commitments, the clearing organization would sell the securities held as collateral. If the value of the collateral were insufficient to repay the loan, a loss would occur, which we may be required to fund. Any such losses could have a material adverse effect on our business, financial condition and operating results.
We rely on our information technology and telecommunication systems, and the failure of these systems could materially and adversely affect our business.
Our businesses are highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to, in our Insurance Services business,
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process new and renewal business, provide customer service, administer claims, make payments on those claims and facilitate collections and, in our Financial Services business, receive and process trade orders. These systems also enable us to perform actuarial and other modeling functions necessary for underwriting and rate development. The failure of these systems, including due to a natural catastrophe or the termination of any third-party software licenses upon which any of these systems is based, could interrupt our operations or materially affect our ability to evaluate and write new business and our ability to receive and process trade orders in our Financial Services business. If our systems or any other systems in the trading process slow down significantly or fail even for a short time, our Financial Services customers would suffer delays in trading, potentially causing substantial losses and possibly subjecting us to claims for such losses or to litigation claiming fraud or negligence.
As our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to write and process new and renewal business and provide customer service or compromise our ability to pay claims in a timely manner. Any interruption in our ability to write and process new and renewal business, service our customers or pay claims promptly could result in a material adverse effect on our business. Any systems failure that interrupts our operations could negatively impact our business, financial condition and operating results.
We are exposed to litigation in our Financial Services business.
From time to time, we are subject to lawsuits and other claims arising out of our Financial Services business. The outcome of these actions cannot be predicted, and such litigation or actions could have a material adverse effect on our results of operations and financial condition. We cannot predict the effect of any current or future litigation, regulatory activity or investigations on our business. Given the current regulatory environment it is possible that we will become subject to further governmental inquiries and subpoenas and have lawsuits filed against us. Our involvement in any investigations and lawsuits would cause us to incur additional legal and other costs and, if we were found to have violated any laws, rules or regulations, we could be required to pay fines, damages and other costs, perhaps in material amounts. We could also be materially adversely affected by the negative publicity related to these proceedings, and by any new industry-wide regulations or practices that may result from these proceedings.
APS Capital Corp., one of our Financial Services subsidiaries, trades bank debt and trade claims which subjects us to potential losses and litigation risk.
APS Capital Corp. (APS Capital), one of our subsidiaries in the Financial Services portion of our business, trades bank debt and trade claims. In that capacity, APS Capital potentially is liable for losses related to the impairment of the traded claims and for disputes that may arise during the trading process from either the holders of, or investors in, bank debt or trade claims.
For losses due to impairment, APS Capital may be liable for the portion of its potential profit on a trade claim trade that is proportional to any part of a traded claim that is subsequently impaired, offset, disallowed, subordinated, or subject to disgorgement (an impairment). Trade claims are private debt instruments representing claims by creditors against a debtor in bankruptcy. On rare occasions, when a trade claim has been allowed by a final, non-appealable court order, APS Capital may provide impairment protection for the full amount of a traded claim. In this case, it is possible that (1) a claim is impaired and (2) APS Capital may be unable to recover the impairment from any prior assignor of the claim. In the process of trading bank debt and trade claims, APS Capital is also subject to general litigation risk, which may result from disputes that arise during its trading process or from particular potential or executed trades.
We currently are party to litigation regarding disputes related to two bankruptcy trade claims. We believe that one of these matters is not material. Due to the recent initiation of the second matter, at this point we are not
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able to accurately quantify potential liability or damages, if any, related to this matter, which involves an assertion that APS Capital failed to acquire trade claims held by a prospective trading partner.
Our compliance and risk management methods might not be effective, which could increase the possibility of regulatory action or litigation or that our business is otherwise negatively impacted.
Our ability to comply with applicable laws and rules is largely dependent on our establishment and maintenance of compliance, audit and reporting systems, as well as our ability to attract and retain qualified compliance and other risk management personnel. Our policies and procedures to identify, monitor and manage our risks may not always succeed. Some methods of risk management are based on the use of observed historical market behavior. As a result, these methods may not accurately predict future risk exposures, which could be significantly greater than the historical measures indicate. Other risk management methods depend on evaluation of information regarding markets, clients or other matters that are publicly available or otherwise accessible by us. This information may not be accurate, complete, current or properly evaluated. Management of operational, market, credit, legal and regulatory risk requires, among other things, policies and procedures to record properly and verify a large number of transactions and events. Our policies and procedures may not always be effective and we may not always be successful in monitoring or evaluating the risks to which we are or may be exposed. The failure to assess and mitigate the risks to which we are exposed could have a material adverse effect on our business, financial condition or results of operation.
RISKS RELATED TO OUR COMMON STOCK AND THIS OFFERING
The market price of our common stock may fluctuate and sales of our common stock, including sales of shares acquired in this offering, could lower the market price of our common stock.
The market price of our common stock may fluctuate in response to quarter-by-quarter variations in our operating results, variations in the operating results of our competitors, changes in our earnings estimates by analysts, developments in the industries in which we operate or changes in general economic conditions.
If a large number of shares of our common stock are sold in the open market after this offering or if there is a perception that such sales will occur, the trading price of our common stock could decrease. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional common stock. Upon consummation of the offering, we will have 6,826,355 shares of our common stock outstanding. Of these shares, all shares sold in the offering, other than shares, if any, purchased by our affiliates and certain shares that are subject to a lock-up, will be freely tradeable.
Currently, there are 1,071,000 shares of our common stock reserved for issuance under our 1995 and 2005 Incentive and Non-Qualified Stock Option Plans. See Description of Capital Stock2005 Incentive and Non-Qualified Stock Option Plan, beginning on page 122. Of these, 760,000 shares of common stock are issuable upon exercise of options outstanding as of the date hereof, of which 552,600 are currently exercisable or will become exercisable within 60 days after April 30, 2007. The sale of shares issued upon the exercise of stock options could further dilute your investment in our common stock and adversely affect our stock price.
In addition, there are 149,500 shares of our common stock reserved for issuance under our Deferred Compensation Plan, of which 95,574 shares of common stock are issuable upon certain key executive officers or directors terminating their employment or association with the Company, respectively. See Description of Capital StockDeferred Compensation Plan, beginning on page 124. As of April 30, 2007, 500 shares of our common stock have been issued under our Deferred Compensation Plan. The sale of shares issued under our Deferred Compensation Plan could adversely affect our stock price and could further dilute your investment in our common stock.
Our common stock has a low average daily trading volume and it may be difficult for you to sell the shares you purchase in this offering.
Our common stock is currently traded on the Nasdaq Capital Market. Stocks trading on the Nasdaq Capital Market typically do not have as high a trading volume as national securities exchanges. As a result, prices quoted
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for our stock may not reflect the actual fair market value of the stock. Also, because of the low volume of trading in our common stock, it may be difficult for you to sell the common stock you purchase in this offering. If you are able to sell our common stock, the limited trading volume could result in a significantly lower sales price than the sales price quoted by the Nasdaq Capital Market at the time of your order to sell. You should consult an experienced investment or financial advisor prior to attempting any sale of our common stock.
Holders of our outstanding shares of preferred stock have rights superior to those of our common shareholders.
The terms of our Series A Redeemable Preferred Stock issued in the acquisition of API provide that no dividends may be paid on shares of our common stock unless we are in compliance with the dividend obligations to holders of the preferred stock. If we are unable to meet the obligations to holders of our preferred stock we will be prohibited from paying dividends on our common stock. Furthermore, in the event we were to be liquidated, holders of our preferred stock would be entitled to receive their full remaining redemption value and any dividends due them before any distribution is made to the holders of our common stock.
A significant portion of our outstanding shares are subject to lock-up agreements which, when they terminate, could result in a large number of our shares being sold, which would lower the price for which people would agree to purchase shares of our common stock.
Pursuant to the terms of our acquisition of API, the approximately 2 million shares of our common stock and approximately 10,198 shares of our Series A redeemable preferred stock issued in the acquisition are subject to a 180-day lock-up period running from April 1, 2007, the date of the effectiveness of the acquisition, until September 28, 2007. We cannot predict whether substantial amounts of our common stock will be offered for sale in the open market upon the expiration of this lock-up period.
In addition, in connection with this offering, we, all of our directors and executive officers, certain other officers and the selling shareholder have entered into lock-up agreements and, with limited exceptions, have agreed not to, among other things, sell or otherwise dispose of our common stock for a period of 180 days after the date of this prospectus other than with respect to a limited number of securities that will be subject to a 90-day lock-up. A substantial amount of our common stock could be sold in the open market in anticipation of, or following, any divestiture by any of our existing shareholders, our directors or executive officers of their shares of common stock.
The net proceeds that we receive from this offering could be deemed to be used for repurchasing our common and preferred shares pursuant to our share repurchase plan and preferred stock redemption requirements.
In connection with our acquisition of API, we issued shares of our Series A redeemable preferred stock. Pursuant to the provision of that series of stock, we are required to redeem approximately $1 million per year of these shares, through the end of 2016. In addition, we have a share purchase plan, whereby we periodically purchase shares of our common stock in the open market and in private transactions. A portion of the net proceeds from this offering will be available for general corporate purposes, which could be deemed to include repurchases of outstanding shares of our preferred stock and common stock.
Anti-takeover provisions in our charter documents, our shareholder rights plan, our outstanding shares of preferred stock and Texas law could prevent or delay a change in control.
Certain anti-takeover provisions could prevent or delay an acquisition of our business at a premium price or at all. Some of these provisions are contained in our articles of incorporation as well as in a shareholder rights plan we adopted. Others are contained in the Texas statutory law governing corporations. These provisions may have the effect of delaying, making more difficult or preventing a change in control or acquisition of us by means of a tender offer, a proxy contest or otherwise. These provisions are expected to discourage certain types of
21
coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of us first to negotiate with us.
Our articles of incorporation provide that we may not engage in certain business combinations with a corporation, subsidiary of a corporation, person or other entity which is the beneficial owner, directly or indirectly, of 20% or more of our outstanding voting shares unless either certain requirements are first satisfied or the transaction is approved by the affirmative vote of no less than two-thirds of the shares of our common stock present in person or by proxy at a meeting where at least 80% of our common shares are represented in person or by proxy.
Under our shareholder rights plan, each outstanding share of common stock has attached to it one purchase right. Each purchase right entitles its holder to purchase from us a unit consisting of one one-thousandth of a share of Series A junior participating preferred stock at a price subject to adjustment. This could prevent or delay our change in control.
The Texas Business Corporations Act provides that certain Texas corporations, including the Company, may not engage in certain business combinations, including mergers, consolidations, and asset sales, with a person, or an affiliate or associate of such person, who is an affiliated shareholder (generally defined as the holder of 20% or more of the corporations voting shares) for a period of three years from the date such person became an affiliated shareholder unless (i) the business combination or purchase or acquisition of shares made by the affiliated shareholder was approved by the board of directors of the corporation before the affiliated shareholder became an affiliated shareholder; or (ii) the business combination was approved by the affirmative vote of the holders of at least 66 2/3% of the outstanding voting shares of the corporation not beneficially owned by the affiliated shareholder, at a meeting of shareholders called for that purpose (and not by written consent), not less than six months after the affiliated shareholder became an affiliated shareholder. Neither our articles of incorporation nor our bylaws contain any provision expressly providing that we will not be subject to the Texas anti-takeover statute. The Texas anti-takeover statute may have the effect of inhibiting a non-negotiated merger or other business combination involving us, even if such event(s) would be beneficial to our shareholders.
Our management shareholders have significant control of us and the ability to influence the approval of matters for which shareholder-voting is involved.
Our executive officers and directors and their affiliates beneficially own approximately 20.6% of our outstanding common stock, assuming full conversion of all options exercisable within 60 days of April 30, 2007, that they may beneficially own. As a result, our management is able to influence and possibly control the election of our board of directors and the outcome of other corporate actions requiring shareholder approval. Assuming the selling shareholder sold the 100,000 shares of our common stock offering and we sold the 2,000,000 shares of our common stock offering pursuant to this prospectus, our executive officers and directors and their affiliates would have beneficially owned approximately 13.5% of our outstanding common stock, assuming full conversion of all options exercisable within 60 days of April 30, 2007.
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act and the Private Securities Litigation Reform Act of 1995, about the Company that are subject to risks and uncertainties. All statements other than statements of historical fact included in this document are forward-looking statements. Forward-looking statements may be found in, among other places, the sections titled Summary, Risk Factors, Managements Discussion and Analysis of Financial Condition and Results of Operations and Business, and elsewhere in this document regarding our financial position, business strategy, possible or assumed future results of operations and other plans and objectives for our future operations and general economic conditions.
You can identify forward-looking statements by the use of words such as may, target, should, will, could, estimates, predicts, potential, continue, anticipates, projects, forecast, believes, plans, expects, future and intends and similar expressions which are intended to identify forward-looking statements. Forward-looking statements are based on beliefs and assumptions made by management using currently available information, such as market and industry materials, experts reports and opinions and trends. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties described in Risk Factors and elsewhere in this prospectus. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors contained in this prospectus. Forward-looking statements contained in this prospectus reflect our view only as of the date of this prospectus. Neither we nor the underwriters undertake any obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
The following important factors, in addition to those discussed under Risk Factors and elsewhere in this document, could affect the future results of our operations and could cause those results to differ materially from those expressed in or implied by such forward-looking statements:
| our use of the net proceeds from this offering; |
| general economic conditions, either nationally or in our market area, that are worse than expected; |
| changes in the healthcare industry; |
| regulatory and legislative actions or decisions that adversely affect our business plans or operations; |
| inflation and changes in the interest rate environment, the performance of financial markets and/or changes in the securities markets; |
| uncertainties inherent in the estimate of loss and loss adjustment expense reserves and reinsurance; changes in the availability or cost of reinsurance; |
| significantly increased competition among insurance providers; |
| potential losses and litigation risk associated with our Financial Services businesses; |
| failure of our trading system resulting in trading and service interruptions, potential loss of revenues or possible litigation; |
| loss of key executives, personnel, accounts or customers; |
| our ability to renew our existing reinsurance or obtain new reinsurance; and |
| failure of our reinsurers to pay claims in a timely manner. |
The foregoing factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this prospectus. We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this prospectus. Before making an investment decision, you should carefully consider all of the factors identified in this prospectus that could cause actual results to differ.
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We estimate that the net proceeds to us from the sale of the 2 million shares of common stock in this offering will be approximately $30.47 million at the public offering price of $16.50 per share and after deducting estimated underwriting discounts and commissions and estimated offering expenses. If the underwriters over-allotment option is exercised in full, we estimate that the net proceeds will be approximately $35.36 million. We will receive no proceeds from the sale of Mr. Shifrins shares.
We intend to use the net proceeds from the sale of our common stock in this offering to implement our business and growth strategy by:
| contributing approximately $10 million of the net proceeds to API, our insurance subsidiary, to increase its capital and surplus base in order to expand in the markets where we currently operate as well as potential new markets and to retain additional premium on the policies we currently underwrite; and |
| using the balance of the net proceeds for working capital, payment of dividends and redemptions of our preferred stock and other general corporate purposes, including possible acquisitions. |
Precise amounts and timing of expenditures will depend on our funding requirements and availability of other capital resources.
Pending use of the net proceeds of this offering, we intend to invest the proceeds in short-term, interest-bearing, investment-grade securities.
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The holders of our common stock are entitled to receive ratably, from funds legally available for the payment thereof, dividends when and as declared by resolution of our board of directors, subject to any preferential dividend rights which may be granted to holders of our preferred stock. As described below, no common stock dividends may be paid in any calendar year unless and until annual dividends on the Series A redeemable preferred stock are paid for that year.
The Series A redeemable preferred stock issued has a redemption value of $1,000 per share for a total redemption value of $10,197,950. We must redeem at least $1 million of the Series A redeemable preferred stock each calendar year beginning in 2007, until December 31, 2016, at which time all of the Series A redeemable preferred stock must have been redeemed. Holders of our Series A redeemable preferred stock are entitled to cumulative dividends at a rate equal to 3% per annum payable on the remaining redemption value per share, in priority to the payments of dividends on our common shares.
Common Stock
On May 8, 2007, our board of directors declared a cash dividend on our common stock of $0.30 to holders of record as of May 18, 2007, which was paid on June 15, 2007. In 2006, 2005 and 2004, we declared cash dividends on our common stock of $0.30, $0.25 and $0.20, respectively, per share of common stock resulting in total dividend payments of approximately $838,000, $671,000 and $518,000, respectively. Prior to 2004, we had never declared or paid any cash dividends on our common stock. Our policy has been to retain our earnings to finance growth and development. The declaration and payment of any future dividends on our common stock is at the sole discretion of our board of directors, subject to our financial condition, capital requirements, future prospects and other factors deemed relevant. See Description of Capital Stock Common Stock, beginning on page 121.
Series A Redeemable Preferred Stock
On May 8, 2007, our board declared its intention to make a payment to redeem, ratably, $1 million of our Series A redeemable preferred stock, together with the required cash dividend equal to 3% per annum of the outstanding redemption value of the Series A redeemable preferred stock, to holders of record as of May 18, 2007. This redemption was made on June 1, 2007, after which there will be approximately 9,198 shares of our Series A redeemable preferred stock outstanding. See Description of Capital Stock Series A Redeemable Preferred Stock, beginning on page 125.
Authorized Preferred Stock
Our charter documents allow our board of directors to create new series of preferred stock and to designate the rights and preferences of each series. Any new series of preferred stock issued by us would likely have dividend, liquidation, voting or other rights that are superior to the rights of our common shareholders. See Description of Capital StockAuthorized Preferred Stock, beginning on page 125.
Restrictions on Dividends by API
We own all of the capital stock of API, our insurance company subsidiary, and anticipate that, from time to time, API may make dividends or distributions to us. In connection with approving our acquisition of API, the Texas Department of Insurance prohibited API from paying dividends to us in any calendar year unless and until we have first complied with our redemption and dividend payment obligations to the holders of our Series A redeemable preferred stock for that year. Also, pursuant to an order of the Texas Department of Insurance, until all of the Series A redeemable preferred stock has been redeemed, API may not make aggregate annual distributions to us in respect of APIs capital stock in excess of the lesser of 10% of APIs prior year-end
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policyholder statutory earned surplus or APIs prior year net income, and in no event may such distributions exceed APIs statutory earned surplus. Following the redemption of all of the Series A redeemable preferred stock, APIs ability to pay dividends to us on its capital stock will continue to be subject to rules and regulations generally applicable to Texas insurance companies.
We do not presently expect any dividends from API to the Company in 2007. As a holding company, our ability to pay expenses and dividends is dependent on our ability to receive dividends from our subsidiaries; however, the management fee we receive, equal to 13.5% of APIs annual earned premiums (before payment of reinsurance premiums), significantly relieves our reliance on dividends from API to pay our operating expenses and service our indebtedness.
See RegulationInsurance Services, beginning on page 96.
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The following table sets forth our capitalization as of March 31, 2007:
| on an actual basis; |
| on a pro forma basis to reflect the issuance of approximately 2 million shares of our common stock and approximately 10,198 shares of our Series A redeemable preferred stock in connection with the acquisition of API; and |
| on a pro forma basis assuming the sale of 2 million shares of common stock by us in this offering at the offering price of $16.50 per share and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Retained earnings has been adjusted by $1,452,000 to give effect to the $.30 per share common dividend declared May 8, 2007 and paid June 15, 2007. |
You should read the information in this table together with our financial statements and notes, Unaudited Pro Forma Condensed Consolidated Financial Information and Managements Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this prospectus.
As of March 31, 2007 | |||||||||
Actual | Pro Forma for Acquisition |
Pro Forma for Offering (as adjusted) | |||||||
(in thousands, except per share data) | |||||||||
Debt |
|||||||||
Series A Redeemable Preferred Stock |
$ | | $ | 9,179 | $ | 9,179 | |||
Shareholders equity: |
|||||||||
Common stock, $0.10 par value; 20,000,000 shares authorized, 2,858,556 shares issued and outstanding, actual; 4,841,055 shares issued and outstanding, pro forma for acquisition; 6,841,055 shares issued and outstanding, pro forma for offering |
286 | 484 | 684 | ||||||
Paid-in capital |
9,432 | 44,195 | 74,468 | ||||||
Retained earnings |
21,016 | 20,756 | 19,304 | ||||||
Accumulated other comprehensive income |
183 | 376 | 376 | ||||||
Total shareholders equity |
30,917 | 65,811 | 94,832 | ||||||
Total capitalization |
$ | 30,917 | $ | 74,990 | $ | 104,011 | |||
The number of shares of our common stock to be outstanding immediately after this offering is based on the number of shares outstanding as of March 31, 2007. This number excludes, as of March 31, 2007:
| 760,000 shares of common stock issuable upon exercise of options outstanding under our 1995 and 2005 Incentive and Non-Qualified Stock Option Plans, at a weighted average exercise price of $12.42 per share; and |
| 206,000 shares of common stock reserved for future grants under our 2005 Incentive and Non-Qualified Stock Option Plan and our Deferred Compensation Plan. |
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Selected Consolidated Historical Financial and Operating Data of American Physicians Service Group, Inc.
The following table sets forth selected historical financial and operating data for the Company. The income statement data set forth below for each of the years in the five-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006, 2005, 2004, 2003 and 2002 are derived from our audited consolidated financial statements included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto, and other information in Managements Discussion and Analysis of Financial Condition and Results of Operations. The income statement data for the three months ended March 31, 2007 and 2006, and the balance sheet data as of March 31, 2007 and 2006, are derived from our unaudited consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All information is presented in accordance with GAAP, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of SFAS No. 123(R). Actual financial results through March 31, 2007 may not be indicative of future financial performance.
Equity compensation costs of approximately $1.2 million related to our acquisition of API are included in the three month period ended March 31, 2007.
Three Months Ended March 31, (unaudited) |
Year Ended December 31, | ||||||||||||||||||||||||||
2007 | 2006 | 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||||
(in thousands, except per share data) | |||||||||||||||||||||||||||
Selected Income Statement Data: |
|||||||||||||||||||||||||||
Revenues: |
|||||||||||||||||||||||||||
Insurance services |
$ | 3,657 | $ | 3,655 | $ | 15,555 | $ | 15,514 | $ | 15,316 | $ | 10,826 | $ | 9,454 | |||||||||||||
Financial services |
5,216 | 3,578 | 16,805 | 18,459 | 16,705 | 19,623 | 13,623 | ||||||||||||||||||||
Total revenues |
8,873 | 7,233 | 32,360 | 33,973 | 32,021 | 30,449 | 23,077 | ||||||||||||||||||||
Expenses: |
|||||||||||||||||||||||||||
Insurance services |
3,823 | 2,754 | 11,262 | 10,262 | 9,968 | 7,841 | 7,066 | ||||||||||||||||||||
Financial services |
4,437 | 3,285 | 15,145 | 16,263 | 14,538 | 16,584 | 11,876 | ||||||||||||||||||||
General and administrative |
777 | 518 | 2,128 | 2,737 | 2,227 | 2,069 | 1,951 | ||||||||||||||||||||
Gain on sale of assets |
(5 | ) | | (29 | ) | (134 | ) | (56 | ) | (8 | ) | (515 | ) | ||||||||||||||
Total expenses |
9,032 | 6,557 | 28,506 | 29,128 | 26,677 | 26,486 | 20,378 | ||||||||||||||||||||
Net income (loss) |
$ | (95 | ) | $ | 562 | $ | 3,194 | $ | 5,460 | $ | 2,152 | $ | 2,799 | $ | 3,411 | ||||||||||||
Per share amounts: |
|||||||||||||||||||||||||||
Basic: Net income (loss) |
$ | (0.03 | ) | $ | 0.20 | $ | 1.15 | $ | 2.03 | $ | 0.85 | $ | 1.27 | $ | 1.53 | ||||||||||||
Diluted: Net income (loss) |
$ | (0.03 | ) | $ | 0.19 | $ | 1.09 | $ | 1.86 | $ | 0.76 | $ | 1.14 | $ | 1.45 | ||||||||||||
Diluted weighted average shares outstanding |
2,822 | 2,909 | 2,933 | 2,931 | 2,838 | 2,449 | 2,345 | ||||||||||||||||||||
Cash dividends |
| | $ | 0.30 | $ | 0.25 | $ | 0.20 | | | |||||||||||||||||
Book value per share |
$ | 10.81 | $ | 10.16 | $ | 10.49 | $ | 9.95 | $ | 9.23 | $ | 7.78 | $ | 8.03 | |||||||||||||
Selected Balance Sheet Data: |
|||||||||||||||||||||||||||
Total assets |
$ | 41,606 | $ | 33,149 | $ | 36,276 | $ | 33,505 | $ | 30,443 | $ | 25,638 | $ | 24,981 | |||||||||||||
Long-term obligations |
| | | | 1,133 | 1,576 | 2,665 | ||||||||||||||||||||
Total liabilities |
10,668 | 5,147 | 6,687 | 5,783 | 6,229 | 6,532 | 7,455 | ||||||||||||||||||||
Minority interests |
21 | 16 | 21 | 15 | 1 | | 384 | ||||||||||||||||||||
Total Shareholders Equity |
$ | 30,917 | $ | 27,986 | $ | 29,568 | $ | 27,707 | $ | 24,213 | $ | 19,106 | $ | 17,142 |
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Selected Historical Financial and Operating Data of American Physicians Insurance Company
The following table sets forth selected historical financial and operating data for API. The income statement data for each of the years in the three-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006 and 2005 are derived from the audited financial statements of API included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto and other information in Managements Discussion and Analysis of Financial Condition and Results of Operations. The income statement data for the year ended December 31, 2003 and the balance sheet data for the year ended December 31, 2004 are derived from the audited financial statements of API. The income statement data for the year ended December 31, 2002 and for the three months ended March 31, 2007 and 2006 and the balance sheet data as of December 31, 2003 and 2002 and March 31, 2007 and 2006 are derived from unaudited financial statements of API which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods and all adjustments are normal recurring in nature. All selected data are presented in accordance with GAAP.
Three Months Ended March 31, |
Year Ended December 31, | |||||||||||||||||||||||||||
2007 | 2006 | 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||
Income Statement Data: |
||||||||||||||||||||||||||||
Gross premiums and maintenance fees writtendirect and assumed |
$ | 15,466 | $ | 20,115 | $ | 74,833 | $ | 79,301 | $ | 84,571 | $ | 70,993 | $ | 58,815 | ||||||||||||||
Premiums ceded |
(2,407 | ) | (2,777 | ) | (4,709 | ) | (12,885 | ) | (12,878 | ) | (10,352 | ) | (7,596 | ) | ||||||||||||||
Net premiums and maintenance fees written |
13,059 | 17,338 | 70,124 | 66,416 | 71,693 | 60,641 | 51,219 | |||||||||||||||||||||
Net premiums and maintenance fees earned |
16,311 | 17,631 | 70,859 | 64,183 | 64,616 | 52,844 | 38,168 | |||||||||||||||||||||
Investment income, net of investment expenses |
1,791 | 1,451 | 6,466 | 5,131 | 4,089 | 3,119 | 3,300 | |||||||||||||||||||||
Realized capital gains (losses)net |
126 | 102 | 6 | 552 | 608 | 185 | (214 | ) | ||||||||||||||||||||
Total revenues |
18,228 | 19,184 | 77,331 | 69,866 | 69,313 | 56,148 | 41,254 | |||||||||||||||||||||
Losses and loss adjustment expenses |
10,934 | 12,153 | 38,970 | 43,976 | 48,655 | 44,546 | 29,616 | |||||||||||||||||||||
Other underwriting expenses and net change in deferred acquisition costs |
3,355 | 3,168 | 14,213 | 12,671 | 11,422 | 9,699 | 10,213 | |||||||||||||||||||||
Total expenses |
14,289 | 15,321 | 53,183 | 56,647 | 60,077 | 54,245 | 39,829 | |||||||||||||||||||||
Income From Operations |
3,939 | 3,863 | 24,148 | 13,219 | 9,236 | 1,903 | 1,425 | |||||||||||||||||||||
Federal income tax expense (benefit) |
1,326 | 1,445 | 8,397 | 4,188 | 3,421 | 1,211 | (116 | ) | ||||||||||||||||||||
Net income |
$ | 2,613 | $ | 2,418 | $ | 15,751 | $ | 9,031 | $ | 5,815 | $ | 692 | $ | 1,541 | ||||||||||||||
GAAP Underwriting Ratios: |
||||||||||||||||||||||||||||
Loss ratio (1) |
||||||||||||||||||||||||||||
Current accident year |
67% | 66% | 61% | 44% | 45% | 64% | 60% | |||||||||||||||||||||
Prior years |
0% | 3% | -6% | 25% | 30% | 20% | 17% | |||||||||||||||||||||
Calendar year |
67% | 69% | 55% | 69% | 75% | 84% | 77% | |||||||||||||||||||||
Expense ratio (2) |
21% | 18% | 20% | 19% | 18% | 18% | 27% | |||||||||||||||||||||
Combined ratio (3) |
88% | 87% | 75% | 88% | 93% | 102% | 104% | |||||||||||||||||||||
Balance Sheet Data: |
||||||||||||||||||||||||||||
Cash and cash equivalents and investments |
$ | 163,457 | $ | 125,702 | $ | 144,583 | $ | 116,749 | $ | 106,457 | $ | 85,671 | $ | 68,582 | ||||||||||||||
Premiums and maintenance fees receivable |
14,647 | 14,427 | 16,493 | 13,703 | 14,971 | 10,354 | 8,294 | |||||||||||||||||||||
Reinsurance recoverables |
31,058 | 34,220 | 37,217 | 34,653 | 16,162 | 18,321 | 19,656 | |||||||||||||||||||||
All other assets |
9,179 | 8,646 | 8,025 | 9,728 | 8,138 | 9,174 | 5,907 | |||||||||||||||||||||
Total Assets |
218,341 | 182,995 | 206,318 | 174,833 | 145,728 | 123,520 | 102,439 | |||||||||||||||||||||
Reserve for losses and loss adjustment expenses |
116,227 | 103,275 | 110,089 | 95,372 | 69,445 | 63,713 | 54,187 | |||||||||||||||||||||
Unearned premiums and maintenance fees |
36,516 | 40,303 | 39,786 | 40,698 | 38,346 | 31,035 | 23,223 | |||||||||||||||||||||
Refundable subscriber deposits |
10,198 | 10,457 | 10,227 | 10,568 | 11,001 | 11,461 | 11,578 | |||||||||||||||||||||
All other liabilities |
18,135 | 8,369 | 11,498 | 8,953 | 15,035 | 11,407 | 8,279 | |||||||||||||||||||||
Total Liabilities |
181,076 | 162,404 | 171,600 | 155,591 | 133,827 | 117,616 | 97,267 | |||||||||||||||||||||
Total Members Equity |
$ | 37,265 | $ | 20,591 | $ | 34,718 | $ | 19,242 | $ | 11,901 | $ | 5,904 | $ | 5,172 |
(1) | Loss ratio is defined as the ratio of losses and loss adjustment expenses to net premiums and maintenance fees earned. |
(2) | Expense ratio is defined as the ratio of other underwriting expenses and net change in deferred acquisition costs to net premiums and maintenance fees earned. |
(3) | Combined ratio is the sum of the loss ratio and the expense ratio. |
29
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL INFORMATION
We are providing the following unaudited pro forma condensed consolidated financial statements to present a picture of the results of operations and financial position of the combined company after giving effect to our acquisition of API, absent any operational or other changes, had APIs and our businesses been combined for the periods and at the dates indicated. The pro forma condensed consolidated balance sheet as of the period ended March 31, 2007 is presented as if the API acquisition occurred on March 31, 2007. The pro forma condensed consolidated statements of operations for the year ended December 31, 2006 and each of the three months ended March 31, 2007 and March 31, 2006 are presented as if the API acquisition occurred on January 1, 2006. The unaudited pro forma condensed consolidated financial statements were prepared using the purchase method of accounting.
The pro forma adjustments are based upon available information and assumptions that each companys management believes are reasonable. The unaudited pro forma condensed consolidated financial statements are presented for illustrative purposes only and are based on the estimates and assumptions set forth in the notes accompanying these statements, which should be read in conjunction with these unaudited pro forma condensed consolidated financial statements. The companies may have performed differently had they always been combined. You should not rely on this information as being indicative of the historical results that would have been achieved had the companies always been combined or the future results that the combined company will experience. The unaudited pro forma condensed consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition. The unaudited pro forma condensed consolidated financial statements and the related notes thereto should be read in conjunction with the audited consolidated financial statements of the Company and the financial statements of API for the years ended December 31, 2006, 2005 and 2004, and unaudited condensed financial statements as of March 31, 2007 and 2006, and for the three months then ended, and the related notes thereto and other information in Selected Historical Consolidated Financial Data and Managements Discussion and Analysis of Financial Condition and Results of Operations.
We recognized equity compensation costs of approximately $1.2 million related to our acquisition of API in the three months ended March 31, 2007, which resulted in a one-time decrease in net income for those three months.
30
Unaudited Pro Forma Condensed Consolidated Balance Sheet
March 31, 2007
(in thousands)
API Historical |
Company Historical |
Pro Forma Adjustments Acquisition |
Pro Forma Combined | |||||||||||
(Note 4) | ||||||||||||||
ASSETS |
||||||||||||||
Investments: |
||||||||||||||
Fixed maturities available-for-sale, at fair value |
$ | 145,354 | $ | 15,114 | $ | $ | 160,468 | |||||||
Fixed maturitiesrestricted, at fair value |
2,498 | 2,498 | ||||||||||||
Equities securities, at fair value |
6,851 | 3,824 | 10,675 | |||||||||||
Short-term investments |
177 | 177 | ||||||||||||
Other invested assets |
1,166 | 505 | (j) | 1,671 | ||||||||||
Total investments |
153,548 | 21,436 | 505 | 175,489 | ||||||||||
Cash and cash equivalents |
9,910 | 4,827 | (35 | )(g) | 14,702 | |||||||||
Cashrestricted |
6,866 | 6,866 | ||||||||||||
Accrued investment income |
793 | 793 | ||||||||||||
Management fees and other receivables |
2,036 | (1,212 | )(a) | 824 | ||||||||||
Premium and maintenance fees receivable |
14,647 | 14,647 | ||||||||||||
Other amounts receivable under reinsurance contracts |
1,373 | 1,373 | ||||||||||||
Reinsurance recoverables on paid & unpaid loss and loss adjustment expenses |
29,685 | (2,735 | )(j) | 26,950 | ||||||||||
Prepaid reinsurance premiums |
311 | 311 | ||||||||||||
Deferred policy acquisition costs |
2,405 | 2,405 | ||||||||||||
Notes receivable |
999 | 999 | ||||||||||||
Deferred tax asset |
4,807 | 1,961 | 6,768 | |||||||||||
Subrogation recoverables |
505 | (93 | )(j) | 412 | ||||||||||
Goodwill |
1,247 | 1,247 | ||||||||||||
Property and equipment |
520 | 520 | ||||||||||||
Other assets |
358 | 1,714 | (965 | )(j) | 1,107 | |||||||||
Total |
$ | 218,342 | $ | 41,606 | $ | (4,535 | ) | $ | 255,413 | |||||
LIABILITIES AND SHAREHOLDERS EQUITY |
||||||||||||||
Liabilities |
||||||||||||||
Reserve for losses and loss adjustment expenses |
$ | 116,227 | $ | $ | $ | 116,227 | ||||||||
Unearned premiums and maintenance fees |
36,516 | 36,516 | ||||||||||||
Reinsurance premiums payable |
253 | 253 | ||||||||||||
Funds held under reinsurance treaties |
11,112 | 11,112 | ||||||||||||
Amounts withheld or retained by the Exchange |
1,360 | 1,360 | ||||||||||||
Refundable subscriber deposits |
10,198 | (10,198 | )(i) | |||||||||||
Mandatorily redeemable preferred stockAPSG |
9,179 | (g) | 9,179 | |||||||||||
Accounts payable |
7,302 | 7,302 | ||||||||||||
Accrued incentive compensation |
533 | 533 | ||||||||||||
Accrued expenses and other liabilities |
2,077 | 2,077 | ||||||||||||
Federal income taxes payable |
2,264 | 498 | (35 | )(h) | 2,727 | |||||||||
Other liabilities |
3,147 | 258 | (1,212 | )(a) | 2,295 | |||||||||
102 | (h) | |||||||||||||
Total Liabilities |
181,077 | 10,668 | (2,164 | ) | 189,581 | |||||||||
Minority interests |
21 | 21 | ||||||||||||
Shareholders Equity |
||||||||||||||
Common stockAPSG |
286 | 198 | (g) | 484 | ||||||||||
Additional paid-in capitalAPSG |
9,432 | 34,763 | (g) | 44,195 | ||||||||||
Retained earningsAPI |
38,955 | (38,955 | )(i) | |||||||||||
Retained earningsAPSG |
21,016 | (193 | )(d) | 20,756 | ||||||||||
(67 | )(h) | |||||||||||||
Accumulated other comprehensive income, net of taxes |
(1,690 | ) | 183 | 1,690 | (i) | 376 | ||||||||
193 | (d) | |||||||||||||
Total Shareholders Equity |
37,265 | 30,917 | (2,371 | ) | 65,811 | |||||||||
Total |
$ | 218,342 | $ | 41,606 | $ | (4,535 | ) | $ | 255,413 | |||||
31
Unaudited Pro Forma Condensed Statement of Operations
For the Three Months Ended March 31, 2007
(in thousands, except per share data)
API Historical |
Company Historical |
Pro Forma Adjustments Acquisition |
Pro Combined |
|||||||||||||
(Note 4) | ||||||||||||||||
REVENUES |
||||||||||||||||
Premiums and maintenance fees written |
$ | 15,466 | $ | | $ | | $ | 15,466 | ||||||||
Premiums ceded |
(2,407 | ) | (2,407 | ) | ||||||||||||
Change in unearned premiums & maintenance fees |
3,252 | 3,252 | ||||||||||||||
Net Premiums and maintenance fees earned |
16,311 | 16,311 | ||||||||||||||
Investment income, net of investment expense |
1,791 | 353 | 78 | (c) | 2,119 | |||||||||||
(117 | )(f) | |||||||||||||||
14 | (d) | |||||||||||||||
Realized capital gains, net |
126 | (334 | ) | (208 | ) | |||||||||||
Financial services |
5,216 | (306 | )(d) | 4,910 | ||||||||||||
Other revenue |
3,657 | (3,718 | )(c) | 33 | ||||||||||||
94 | (e) | |||||||||||||||
Total revenues |
18,228 | 8,892 | (3,955 | ) | 23,165 | |||||||||||
EXPENSES |
||||||||||||||||
Losses and loss adjustment expenses |
10,934 | (1,001 | )(c) | 11,171 | ||||||||||||
1,238 | (f) | |||||||||||||||
Other underwriting expenses |
3,214 | 1,572 | (f) | 3,230 | ||||||||||||
(1,650 | )(c) | |||||||||||||||
94 | (e) | |||||||||||||||
Amortization of deferred policy acquisition costs |
141 | 141 | ||||||||||||||
General and administrative |
4,600 | (5) | (989 | )(c) | 786 | |||||||||||
(2,927 | )(f) | |||||||||||||||
102 | (h) | |||||||||||||||
Financial services expenses |
4,437 | 4,437 | ||||||||||||||
Total expenses |
14,289 | 9,037 | (3,561 | ) | 19,765 | |||||||||||
Income from operations |
3,938 | (145 | ) | (394 | ) | 3,400 | ||||||||||
Federal income tax expense |
1,326 | (49 | ) | (35 | )(h) | 1,143 | ||||||||||
(99 | )(d) | |||||||||||||||
Minority interests |
(1 | ) | (1 | ) | ||||||||||||
Net income (loss) |
$ | 2,613 | $ | (95 | ) | $ | (260 | ) | $ | 2,258 | ||||||
Net Income (Loss) Per Share: (Note 6) |
||||||||||||||||
Basic |
$ | (0.03 | ) | $ | 0.47 | |||||||||||
Diluted |
$ | (0.03 | ) | $ | 0.46 | |||||||||||
Basic weighted average shares outstanding |
2,822 | 1,983 | 4,805 | |||||||||||||
Diluted weighted average shares outstanding |
2,822 | 2,106 | 4,928 |
32
Unaudited Pro Forma Condensed Statement of Operations
For the Three Months Ended March 31, 2006
(in thousands, except per share data)
API Historical |
Company Historical |
Pro Forma Adjustments Acquisition |
Pro Forma Combined |
||||||||||||
(Note 4) | |||||||||||||||
REVENUES |
|||||||||||||||
Premiums and maintenance fees written |
$ | 20,115 | $ | | $ | | $ | 20,115 | |||||||
Premiums ceded |
(2,777 | ) | (2,777 | ) | |||||||||||
Change in unearned premiums & maintenance fees |
293 | 293 | |||||||||||||
Net Premiums and maintenance fees earned |
17,631 | 17,631 | |||||||||||||
Investment income, net of investment expense |
1,451 | 203 | 87 | (c) | 1,682 | ||||||||||
(67 | )(f) | ||||||||||||||
8 | (d) | ||||||||||||||
Realized capital gains, net |
102 | 7 | 109 | ||||||||||||
Financial services |
3,578 | (121 | )(d) | 3,457 | |||||||||||
Other revenue |
3,655 | (3,648 | )(c) | 101 | |||||||||||
94 | (e) | ||||||||||||||
Total revenues |
19,184 | 7,443 | (3,647 | ) | 22,980 | ||||||||||
EXPENSES |
|||||||||||||||
Losses and loss adjustment expenses |
12,153 | (986 | )(c) | 11,925 | |||||||||||
758 | (f) | ||||||||||||||
Other underwriting expenses |
3,206 | 997 | (f) | 2,472 | |||||||||||
(1,298 | )(c) | ||||||||||||||
94 | (e) | ||||||||||||||
(527 | )(b) | ||||||||||||||
Amortization of deferred policy acquisition costs |
(38 | ) | (38 | ) | |||||||||||
General and administrative |
3,272 | (1,277 | )(c) | 275 | |||||||||||
(1,822 | )(f) | ||||||||||||||
102 | (h) | ||||||||||||||
Financial services expenses |
3,285 | 3,285 | |||||||||||||
Total expenses |
15,321 | 6,557 | (3,959 | ) | 17,919 | ||||||||||
Income from operations |
3,863 | 886 | 312 | 5,061 | |||||||||||
Federal income tax expense |
1,445 | 323 | (35 | )(h) | 1,516 | ||||||||||
(38 | )(d) | ||||||||||||||
(179 | )(b) | ||||||||||||||
Minority interests |
1 | 1 | |||||||||||||
Net income |
$ | 2,418 | $ | 562 | $ | 564 | $ | 3,544 | |||||||
Net Income per Share: (Note 6) |
|||||||||||||||
Basic |
$ | 0.20 | $ | 0.75 | |||||||||||
Diluted |
$ | 0.19 | $ | 0.72 | |||||||||||
Basic weighted average shares outstanding |
2,762 | 1,983 | 4,745 | ||||||||||||
Diluted weighted average shares outstanding |
2,909 | 1,983 | 4,892 |
33
Unaudited Pro Forma Condensed Statement of Operations
For the Year Ended December 31, 2006
(in thousands, except per share data)
API Historical |
Company Historical |
Pro Forma Adjustments Acquisition |
Pro Forma Combined |
||||||||||||
(Note 4) | |||||||||||||||
REVENUES |
|||||||||||||||
Premiums and maintenance fees written |
$ | 74,833 | $ | | $ | | $ | 74,833 | |||||||
Premiums ceded |
(4,709 | ) | (4,709 | ) | |||||||||||
Change in unearned premiums & maintenance fees |
735 | 735 | |||||||||||||
Net Premiums and maintenance fees earned |
70,859 | 70,859 | |||||||||||||
Investment income, net of investment expense |
6,466 | 945 | 236 | (c) | 7,635 | ||||||||||
(158 | )(f) | ||||||||||||||
146 | (d) | ||||||||||||||
Realized capital gains, net |
6 | 269 | 275 | ||||||||||||
Financial services |
16,805 | (755 | )(d) | 16,050 | |||||||||||
Other revenue |
15,555 | (15,610 | )(c) | 320 | |||||||||||
375 | (e) | ||||||||||||||
Total revenues |
77,331 | 33,574 | (15,766 | ) | 95,139 | ||||||||||
EXPENSES |
|||||||||||||||
Losses and loss adjustment expenses |
38,970 | (4,278 | )(c) | 37,568 | |||||||||||
2,876 | (f) | ||||||||||||||
Other underwriting expenses |
12,971 | 4,337 | (f) | 11,233 | |||||||||||
(6,450 | )(c) | ||||||||||||||
375 | (e) | ||||||||||||||
Amortization of deferred policy acquisition costs |
(39 | ) | (39 | ) | |||||||||||
General and administrative |
1,281 | 13,390 | (4,646 | )(c) | 3,062 | ||||||||||
(7,371 | )(f) | ||||||||||||||
408 | (h) | ||||||||||||||
Financial services expenses |
15,145 | 15,145 | |||||||||||||
Total expenses |
53,183 | 28,535 | (14,749 | ) | 66,969 | ||||||||||
Income from operations |
24,148 | 5,039 | (1,017 | ) | 28,170 | ||||||||||
Federal income tax expense |
8,397 | 1,839 | (139 | )(h) | 9,890 | ||||||||||
(207 | )(d) | ||||||||||||||
Minority interests |
6 | 6 | |||||||||||||
Net income |
$ | 15,751 | $ | 3,194 | ($ | 671 | ) | $ | 18,274 | ||||||
Net Income per Share: (Note 6) |
|||||||||||||||
Basic |
$ | 1.15 | $ | 3.84 | |||||||||||
Diluted |
$ | 1.09 | $ | 3.72 | |||||||||||
Basic weighted average shares outstanding |
2,774 | 1,983 | 4,757 | ||||||||||||
Diluted weighted average shares outstanding |
2,933 | 1,983 | 4,916 |
34
Notes to Unaudited Pro Forma Condensed
Consolidated Financial Statements
1. Basis of Presentation
The accompanying unaudited pro forma balance sheet and statements of operations present the pro forma effects of our acquisition of API through the issuance of common and preferred shares of our stock. The balance sheet is presented as though the acquisition occurred on March 31, 2007. The statements of operations for the three months ended March 31, 2007 and March 31, 2006 and the year ended December 31, 2006, are presented as though the acquisition occurred on January 1, 2006.
2. Method of Accounting for the Acquisition
We accounted for the acquisition using the purchase method of accounting for business combinations. We were deemed to be the acquirer for accounting purposes based on a number of factors determined in accordance with GAAP. The purchase method of accounting requires that APIs assets acquired and liabilities assumed by us be recorded at their estimated fair values.
3. Adjustments to Historical Financial Statements for Comparability
API, in conformity with GAAP as applied to insurance companies, prepares its balance sheet without classification as to the short- and long-term nature of its assets and liabilities. Following the acquisition, we are primarily an insurance company and, accordingly, we have reclassified our balance sheet and statements of operations in the unaudited pro forma financial information to conform to GAAP as applied to insurance companies.
4. Pro Forma Adjustments Related to the Acquisition
Pursuant to our acquisition of API, API became a wholly owned subsidiary of the Company.
At the effective time of the acquisition, April 1, 2007, each share of common stock of API was converted into, and exchanged for, the right to receive the number of shares of our common stock based upon an exchange ratio equal to a purchase price of $39 million minus the $9,179,000 agreed-upon present value of the payments authorized by the Texas Department of Insurance that must be made by us to comply with the mandatory redemption features of the API Series A redeemable preferred stock in exchange for the API refundable deposit certificates, divided by $17.28, divided by the 10,000,000 shares of API common stock. The $17.28 price was the average closing price of our common shares for the twenty trading days immediately preceding the closing. According to the terms of the merger agreement for the acquisition, the value of our common stock issued in the acquisition was subject to adjustment upwards or downwards by up to 15% based on the closing price of our common shares for the twenty trading days immediately preceding the effective date of the acquisition.
Each share of Series A redeemable preferred stock of API was converted into the right to receive one share of our Series A redeemable preferred stock. The shares of our common stock and Series A redeemable preferred stock issued in the acquisition are subject to a 180-day lock-up period in which the holders of such shares are prohibited from transferring their shares. This lock-up period expires on September 28, 2007.
The purchase accounting and pro forma adjustments related to unaudited pro forma balance sheet and statements of operations as a result of the acquisition are as follows:
(a) | Eliminates intercompany receivables and payables between the Company and API as of March 31, 2007. |
(b) | For the period ended March 31, 2006, API had recorded the pro rata portion of the annual profit sharing component of the management fee expense. In 2006 we did not recognize any of the profit |
35
sharing component of the management fee revenue until December. Consequently, to make the historical statements consistent and comparable to each other, $527,000 of other underwriting expense related to the profit-sharing component of management fees has been eliminated and federal income tax expense has been adjusted accordingly ($179,000) for the three months ended March 31, 2006. For the three months ended March 31, 2007, both API and the Company recognized a corresponding expense and revenue for the profit sharing component of the management fee and this elimination is reflected with item (c) below. |
(c) | Records the elimination of the revenue component of management fee and sub-producer commissions by the Company, the management fee expense by API and the sub-producer expenses by the Company for the three months ended March 31, 2007, the three months ended March 31, 2006 and the year ended December 31, 2006. |
(d) | Records the elimination of intercompany revenue by APS Investment Services for investment trading fees for managing APIs fixed income investment portfolio and records related other comprehensive income at API, change in amortization of bond premium and tax expense. The net effect on retained earnings is $193,000 and $75,000 for the three months ended March 31, 2007 and March 31, 2006, respectively. The net effect on retained earnings was $402,000 for the twelve months ended December 31, 2006. |
(e) | Records commissions expense incurred by API that is currently reimbursed by the Company. There is no reimbursement following the acquisition. The reimbursement was eliminated in our financial statements. |
(f) | Reclassifies the salaries, marketing, professional fees and general administrative expenses of the attorney-in-fact supporting the functional areas of claims, underwriting and investments. |
(g) | Records our common stock, preferred stock and cash issued for API common stock and API preferred stock as part of the acquisition. Described below is the calculation of common stock as defined in the merger agreement for the acquisition and the basis of recording our mandatorily redeemable preferred stock issued in the acquisition. |
The common stock component of the acquisition consideration, as follows:
Agreed price for our common and preferred stock: |
$ | 39,000,000 | ||
Less: value of the Series A redeemable preferred shares: |
(9,179,000 | ) | ||
Agreed value of our common stock: |
$ | 29,821,000 |
The merger agreement specified that the price per share of our common stock was the average of the closing price of the stock over the 20 days including and preceding April 1, 2007, which was $17.28. The agreement also specified certain adjustments made to the value of common stock issued based on average closing prices of our common stock prior to the acquisition. Pursuant to the terms of the merger agreement and based on the 20-day average trading price of our common stock prior to the acquisitions effective date, the value of common stock issued was increased by 15%.
$29,821,000 x 115% | = 1,985,000 shares
| |
$17.28 |
Fractional shares totaling approximately 2,000 shares were purchased for cash of $35,000, reducing shares issued to 1,983,000.
The fair value of the 1,983,000 shares of common stock issued in the transaction was $34,961,000 based on the $17.635 average closing price in the two trading days preceding and following the April 1, 2007 closing date.
Capital stock at $0.10 par value: |
$ | 198,000 | |
Additional paid in capital: |
34,763,000 | ||
Value of our common stock |
$ | 34,961,000 | |
The value of our Series A redeemable preferred stock is defined in the merger agreement as the value of the API Series A redeemable preferred stock, the value of which is based on the balance of APIs refundable surplus at the closing.
36
We issued Series A redeemable preferred stock in exchange for API redeemable preferred stock as part of the consideration in our acquisition of API. API Series A redeemable preferred stock was created when holders of API refundable deposit certificates exchanged those certificates for the Series A redeemable preferred stock. Pursuant to Financial Accounting Standards Board (FASB) Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (FASB No. 150), an issuer is required to classify an instrument as a liability if it is issued in the form of shares that are mandatorily redeemable if it embodies an unconditional obligation that requires the issuer to redeem the shares by transferring the entitys assets at a specified or determinable date(s) or upon an event that is certain to occur. The preferred stocks mandatory cash redemption feature coupled with a fixed redemption date and fixed amount requires that it be classified as debt, rather than equity. Terms of the merger agreement call for the stock to be redeemed over ten years with a 3% per annum dividend rate. The Texas Department of Insurances approval of the acquisition was conditioned upon us maintaining certain funds in escrow. We have placed $2.5 million in an escrow account with a bank to remain until the aggregate remaining redemption obligation on our outstanding Series A redeemable preferred stock is less than the amount of the escrow balance, with no withdrawals to be made from this escrow account without prior approval from the Texas Department of Insurance. Pursuant to FASB No. 150, the redeemable preferred stock will be recorded at fair market value calculated at its present value based on our rate of return on investment assets, 5.35%, which is $9,179,000.
(h) | Records the 3% per annum dividend on our Series A redeemable preferred stock and the imputed interest from recording the liability at fair value. |
(i) | Eliminates the equity of API in consolidation, including the refundable surplus deposits, which are classified as debt. |
(j) | In June 2001, FASB issued Statement No. 141, Business Combinations (FASB No. 141) and Statement No. 142, Goodwill and Other Intangible Assets. In accordance with these pronouncements, when there is an excess of fair value of acquired net assets over their cost, the excess shall be allocated as a pro rata reduction of the amounts that otherwise would have been assigned to the non-current assets, except financial assets, assets to be disposed of by sale, deferred tax assets and prepaid assets relating to pension or other post-retirement benefits. |
The excess of fair value of acquired net assets over cost is as follows:
Acquisition consideration |
|||
Common stock: |
$ | 34,961,000 | |
Preferred stock: |
9,179,000 | ||
Cash: |
35,000 | ||
Transaction costs |
965,000 | ||
Total purchase price |
45,140,000 | ||
API stated equity |
37,265,000 | ||
Add: Adjustment of assets to fair value |
505,000 | ||
Debt to be replaced by our Series A redeemable preferred stock |
10,198,000 | ||
Net assets acquired at fair value |
$ | 47,968,000 | |
Excess of fair value of acquired net assets over cost |
$ | 2,828,000 | |
The allocation of excess fair value over costs to acquired API assets is as follows:
Asset classification |
Total | Long-term Portion |
% | Adjustment | |||||||||
Reinsurance recoverables |
$ | 29,685 | $ | 14,697 | 96.7 | % | $ | (2,735 | ) | ||||
Subrogation recoverables |
505 | 505 | 3.3 | % | (93 | ) | |||||||
$ | 30,190 | $ | 15,202 | 100 | % | $ | (2,828 | ) | |||||
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The adjustment of assets to fair value shown above represents the adjustment to present value of a receivable with an interest rate in excess of current market interest rates. The carrying value of all other assets and liabilities was reviewed and determined to be an accurate representation of fair value. API has no fixed assets, a common area for adjustments. Its largest asset, its investment portfolio, is adjusted to market value in its GAAP financial statements, and its other assets and liabilities are of short duration and will be realized/paid at their carrying value. We also reviewed API for intangible assets that could result from the acquisition. We reviewed trademarks and trade names and determined that they would not carry over to the new entity. We considered customer lists and determined that there was no information that was not readily available from the Texas Board of Medical Examiners. We examined customer relationships and, while we consider them good, we do not believe they provide an advantage over our two larger competitors in this highly-competitive environment. No other intangibles, as defined in FASB No. 141, were determined to be applicable. This transaction was finalized in April 2007. The purchase price allocation is preliminary and may be adjusted based on the companys final assessment of information related to the estimated fair value of assets obtained and consideration given.
5. At a meeting of the board of directors on March 23, 2007, following shareholder approval of the acquisition on March 22, 2007, in connection with the establishment of APIs Advisory Board, we issued options to purchase 148,000 shares of our common stock to the directors of API, which includes options granted to two of our new directors, Dr. Knight and Dr. Peche. At this meeting, we also issued equity awards to certain employees who were instrumental in accomplishing the acquisition. The total expense of these equity awards was approximately $1.2 million and is included in our historical financial statements at March 31, 2007.
6. Common Shares Outstanding
Pro forma net income per share for each of the three months ended March 31, 2007 and 2006 and the year ended December 31, 2006 have been calculated based on the weighted average number of shares outstanding as follows:
Three Months Ended March 31, 2007 |
Three Months Ended March 31, 2006 |
Year Ended December 31, 2006 | ||||
(in thousands) | ||||||
Basic: |
||||||
Weighted average common shares outstanding |
2,822 | 2,762 | 2,774 | |||
Shares issued in the acquisition transaction |
1,983 | 1,983 | 1,983 | |||
Pro forma weighted average shares outstanding |
4,805 | 4,745 | 4,757 | |||
Diluted: |
||||||
Weighted average common shares outstanding |
2,822 | 2,909 | 2,933 | |||
Shares issued in the acquisition transaction |
2,106 | 1,983 | 1,983 | |||
Pro forma weighted average shares outstanding |
4,928 | 4,892 | 4,916 | |||
Included in the pro forma diluted weighted average shares outstanding for the three month ended March 31, 2007 is the effect of 123 potential common shares, the impact of which was considered to be anti-dilutive on a historical basis.
7. Book Value per Share
Had the acquisition taken place at March 31, 2007, pro forma book value per share would be as follows:
API Historical 2007 |
Company Historical March 31, 2007 |
Pro Forma Adjustments Acquisition |
Pro Forma Combined March 31, 2007 | ||||||||||
(Note 4) | |||||||||||||
Common shares issued and outstanding |
| 2,859 | 1,983 | 4,842 | |||||||||
Total Shareholders Equity |
$ | 37,265 | $ | 30,917 | $ | (2,371 | ) | $ | 65,811 | ||||
Book Value per Share |
$ | 10.81 | $ | 13.59 |
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MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the unaudited financial statements and related notes for the period ended March 31, 2007 and March 31, 2006 for the Company and API, included elsewhere in this prospectus and the audited financial statements and related notes for the period ended December 31, 2006, 2005 and 2004 for the Company and API, included elsewhere in this prospectus. The discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to these differences include those discussed in Risk Factors.
Overview
We are a holding company with two primary operating segments: Insurance Services and Financial Services.
Insurance Services
With the acquisition of API on April 1, 2007, we anticipate that our long-term consolidated revenue and earnings will be predominately derived from medical professional liability insurance provided through our Insurance Services segment. Historically, revenue from our Insurance Services segment contributed approximately 48%, 46% and 48% of our total revenue in 2006, 2005 and 2004, respectively and 41% in the first quarter of 2007. The past results of our Insurance Services segment were materially impacted by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations such as personnel expenses, rent, office expenses and technology costs. API was responsible for claim costs, actuarial and accounting fees, reimbursing us for independent agent commissions paid on its behalf and other specific expenses incurred in its operations. Management fees equaled 13.5% of APIs earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of APIs pre-tax profits up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Due to this management fee structure, results of our Insurance Services segment were dependent upon premiums generated by API as well as its overall profitability.
As a result of our acquisition of API, these management fees will no longer affect the Companys consolidated results of operations. For a better understanding of the Companys financial results had we acquired API before April 1, 2007, please refer to the unaudited pro forma condensed consolidated financial statements included elsewhere herein and related notes thereto. For example, on a pro forma basis, as if the acquisition of API had occurred on January 1, 2006, total revenue and pre-tax earnings from our Insurance Services segment would have contributed approximately 82% and 93% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, for the year ended December 31, 2006, and approximately 79% and 88% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, for the three months ended March 31, 2007.
When we acquired API, our management agreement with API was terminated and replaced with an intercompany management agreement. Our results of operations are now directly affected by premiums we earn from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies we write as well as commissions and other insurance underwriting and policy acquisition expenses we incur.
Prior to tort reform legislation in 2003, the Texas medical professional liability market experienced rate increases as a result of increases in claim frequency and severity. As rates continued to increase, physicians sought lower limits of coverage in order to lower their cost of coverage. The shift to lower limits resulted in lower premiums being paid; however, the lower premiums paid as a result of this shift were offset by average annual rate increases of approximately 22% for each of the years 2000 through 2003. Since the passage of tort reform, an improved claim environment and rate adequacy have allowed API to hold rates relatively level in
39
2004 and lower its rates approximately 9% in 2005, 18% in 2006 and an additional 18% for policies renewing in the first quarter of 2007, while reporting strong financial results of operations and net income.
We anticipate that our future Insurance Services results of operations will be impacted by the long-term effects of the rate environment and tort reform legislation in the State of Texas, which capped non-economic damages and placed restrictions on mass litigation. The post-tort reform environment in Texas has caused increased competition by both existing professional liability carriers and new entrants into the marketplace, which we expect to continue throughout 2007. As a result of this increased competition, our Insurance Services operations will face price pressure on both existing renewals and new business. We plan to monitor the frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted and will continue to price insurance products at rates believed to be adequate for the risks assumed.
Financial Services
Our Financial Services segment reflects the results of our investment and investment advisory subsidiaries, APS Financial Corporation (APS Financial), APS Capital Corp. (APS Capital) and APS Asset Management, Inc. (Asset Management). The results of our Financial Services segment are primarily affected by commissions and markups received on securities trading and the clearing of trade claims, asset management fees and the expenses incurred in operating our Financial Services segment. Trade claims are private debt instruments representing claims by creditors against a debtor in bankruptcy. We recognize commissions revenue and the related compensation expense when a trade claim transaction is complete and fully funded. Revenues from our Financial Services segment were 52%, 54% and 52% of our total revenues in 2006, 2005 and 2004, respectively, for the year ended December 31, and 59% of our total revenues in the first three months of 2007. For example, on a pro forma basis, as if the acquisition of API had occurred on January 1, 2006, total revenue and pre-tax earnings from our Financial Services segment would have contributed approximately 17% and 3% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, for the year ended December 31, 2006, and approximately 21% and 11% of our total revenues and pre-tax earnings before accounting for corporate overhead, respectively, for the three months ended March 31, 2007.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to impairment of assets, bad debts, income taxes and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Following the acquisition of API, we are primarily an insurance company and, as such, make estimates and judgments about reported items such as reserve for loss and loss adjustment expense, reinsurance, deferred policy acquisition costs and death, disability and retirement reserves. As such, the following discussion also includes a discussion of critical accounting policies and estimates specific to APIs historical financial statements.
We believe the following critical accounting policies and estimates affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Critical Accounting Policies and Estimates for the Company
The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to impairment of assets, bad debts, income taxes and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying
40
values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies and estimates affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. The Company recognizes revenue in accordance with Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in the Financial Statements. Prior to April 1, 2007, our Insurance Services revenues were historically related to management fees based on the earned premiums of API and included a profit sharing component related to APIs annual earnings. Management fees equaled 13.5% of APIs earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of APIs pre-tax profits up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Management fees are recorded, based upon the terms of the management agreement, in the period the related premiums are earned by API. API recognizes premiums as earned ratably over the terms of the related policy. The profit sharing component was historically recognized in the fourth quarter when it was certain API would have an annual profit. In 2007, however, we recorded this profit sharing component through March 31, 2007 as a result of the acquisition effective April 1, 2007.
Our Financial Services revenues are composed primarily of commissions on securities trades, clearing of trade claims and asset management fees. Revenues related to securities transactions are recognized on a trade-date basis. Revenues from the clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios are recognized when the transaction is complete and fully funded. Asset management fees are recognized as a percentage of assets under management during the period based upon the terms of agreements with the applicable customers.
Allowances for Doubtful Accounts. When necessary, we record an allowance for doubtful accounts based on specifically identified amounts that we believe to be uncollectible. Management analyzes historical collection trends and changes in its customers payment patterns, customer concentration and creditworthiness when evaluating its allowance for doubtful accounts.
If our actual collections experience changes, revisions to our allowance may be required. We have a limited number of customers with individually large amounts due at any given balance sheet date. Any unanticipated change in one of those customers credit standing or rating could have a material affect on our results of operations in the period in which such changes or events occur. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.
Stock-Based Compensation. In December 2004, FASB issued SFAS No. 123(R), which revised SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), and we were required to adopt SFAS No. 123(R) in the first quarter of 2006. SFAS No. 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related interpretations, and requires that all stock-based compensation, including options, be expensed at fair value, as of the grant date, over the vesting period. Companies are required to use an option pricing model (e.g., Black-Scholes or Binomial) to determine compensation expense, consistent with the model previously used in the already required disclosures of SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS No. 148).
For the year ended December 31, 2006 and the three months ended March 31, 2007, we calculated stock-based compensation using the intrinsic value method. We estimate the fair value of stock option awards on the date of grant utilizing a modified Black-Scholes option-pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of short-term traded options that have no vesting restrictions and are fully transferable. However, certain assumptions used in the Black-Scholes model, such as expected term, can be adjusted to incorporate the unique characteristics of our stock option awards. Option valuation models require the input of somewhat subjective assumptions including expected stock price volatility and expected term. We believe it is unlikely that materially different estimates for the assumptions used in
41
estimating the fair value of stock option grants would be made based on conditions suggested by actual historical experience and other data available at the time estimates were made. Restricted stock awards are valued at the price of our common stock on the date of grant.
At March 31, 2007, we had several stock-based compensation plans, which are described more fully in Notes 12 and 13 to the audited consolidated financial statements contained herein. Prior to January 1, 2006, we accounted for these plans under the recognition and measurement principles of APB No. 25, under which stock-based employee compensation cost was not reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In accordance with SFAS No. 123, as amended by SFAS No. 148, we provided footnote disclosure of the pro forma stock-based compensation cost, net loss and net loss per share as if the fair value based method of expense recognition and measurement prescribed by SFAS No. 123 had been applied to all employee options.
As a result of adopting SFAS No. 123(R) on January 1, 2006, our net income for the three months ended March 31, 2007 was $605,000 less than it would have been if we had continued to account for stock-based compensation under APB No. 25. Basic and diluted net income per share would be $0.21 and $0.21 more, respectively, if we had continued to account for the stock-based compensation under APB No. 25. Our net income for the three months ended March 31, 2006 was $18,000 less than it would have been if we had continued to account for stock-based compensation under APB No. 25. Basic and diluted net income per share would be unaffected for this period if we had continued to account for the stock-based compensation under APB No. 25. The adoption of SFAS No. 123(R) had no effect on our cash flows in the three months ended March 31, 2007 or the year ended December 31, 2006, as stock option expense is a non-cash charge.
Investments. We account for our equity and fixed-income securities as available-for-sale. In the event a decline in fair value of an investment occurs, management may be required to determine if the decline in market value is other than temporary. Our policy is to account for investments as available-for-sale securities which requires that we assess fluctuations in fair value and determine whether these fluctuations are temporary or other than temporary as defined in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, as amended. Managements assessments as to the nature of a decline in fair value are based on the quoted market prices at the end of a period, the length of time an investments fair value has been in decline and our ability and intent to hold the investment until a recovery in value. If the fair value is less than the carrying value and the decline is determined to be other than temporary, a write-down is recorded against earnings in the period such determination is made.
As of March 31, 2007, we owned 385,000 shares of Financial Industries Corporation (FIC), representing approximately 4% of its outstanding common stock. Temporary changes in fair value are recognized as unrealized gains or losses excluded from earnings and reported in equity as a component of accumulated other comprehensive income, net of income taxes. Should a decline in an investment be deemed other than temporary, as was the case with our investment with FIC in 2004, 2005, 2006 and the first quarter of 2007, pre-tax charges to earnings will be taken in the period in which the impairment is considered to be other than temporary.
Asset Impairment. We periodically review the carrying value of our assets to determine if events and circumstances exist indicating that assets might be impaired. If facts and circumstances support this possibility of impairment, our management will prepare undiscounted and discounted cash flow projections, which require judgments that are both subjective and complex. Management may also obtain independent valuations.
Business Combinations. We recorded all assets and liabilities acquired in the acquisition of API, including goodwill, indefinite-lived intangibles, and other intangibles, at fair value as required by SFAS No. 141. The initial recording of goodwill and other intangibles requires subjective judgments concerning estimates of the fair value of the acquired assets and liabilities. Goodwill and indefinite-lived intangible assets are not amortized but are subject to annual tests for impairment or more often if events or circumstances indicate they may be
42
impaired. Other identified intangible assets are amortized over their estimated useful lives and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The on-going value of goodwill is ultimately supported by revenue from our business sectors and our ability to deliver cost-effective services over future periods. Any decline in revenue resulting from a lack of growth or the inability to effectively provide services could potentially create an impairment of goodwill.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believe it is more likely than not our deferred tax assets will be fully recovered.
Critical Accounting Policies and Estimates for API
The accompanying financial statements have been prepared in accordance with GAAP. The preparation of GAAP financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates included in the accompanying financial statements are the reserve for losses and loss adjustment expenses, death, disability and retirement reserves, provision for federal income taxes, reinsurance premiums recoverable/payable and premiums ceded. Other critical accounting policies include revenue recognition, deferred policy acquisition costs and refundable deposits.
API considers the following accounting policies to be critical because they involve significant judgment by its management and the effect of those judgments could result in a material effect on the financial statements.
Reserve for Loss and Loss Adjustment Expense. Loss and loss adjustment expense reserves represent managements best estimate of the ultimate costs of all reported and unreported losses incurred. API writes substantially all of its policies on a claims-made basis, and the reserve for unpaid loss and loss adjustment expense are estimated using actuarial analysis. These estimates include expectations of what the ultimate settlement and administration of claims will cost based on the companys assessments of facts and circumstances then known, review of historical settlement patterns, estimates in trends in loss severity, frequency, legal theories of liability and other factors. Other factors include the nature of the injury, the judicial climate where the insured event occurred and trends in healthcare costs. In addition, variables in reserve estimation can be affected by both internal and external events, such as economic inflation, legal trends and legislative changes. The estimation of medical professional liability insurance loss and loss adjustment expense is inherently difficult. Injuries may not be discovered until years after an incident, or a claimant may delay pursuing recovery for damages. Medical liability claims are typically resolved over an extended period of time, often five years of more.
Insurance product lines are classified as either short tail or long tail based on the average length between the event triggering claims under a policy and the final resolution of those claims. Short tail claims are reported and settled quickly, resulting in less estimation variability. The longer the time (long tail) before the final resolution which is the case with medical professional liability, there is greater exposure to estimation risk and hence the greater the estimation uncertainty. Additional deviations in the data such as changes in specialties, limits or territories can make forecasting a long tail business such as medical professional liability insurance difficult.
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The combination of changing conditions and the extended time required for claim resolution results in a loss estimation process that requires actuarial skill and the application of judgment, and such estimates require periodic revisions. APIs management performs an in-depth review of the reserve for unpaid losses and loss adjustment expenses on a semi-annual basis with assistance from its outside consulting actuary.
The independent review of reserves by APIs outside consulting actuary plays an important role in the overall assessment of the adequacy of reserves. API establishes reserves for unpaid loss and loss adjustment expenses taking into account the results of multiple actuarial techniques applied as well as other assumptions and factors regarding its business. The actuarial techniques used that are material to the evaluation of reserves for unpaid loss and loss adjustment expense include the following:
| Loss Development Methods (Incurred and Paid Development); |
| Loss Adjustment Expense Development Methods (Incurred and Paid Development); |
| Average hindsight outstanding projection; |
| Frequency/Severity Projection Methods; |
| Bornhuetter-Ferguson Expected Loss Projection Methods; and |
| Trended pure premium method. |
Each technique has inherent benefits and shortcomings (i.e., biases), particularly when applied to company-specific characteristics and trends. For example, certain methods (e.g., the Bornhuetter-Ferguson and pure premium methods) are more relevant to immature accident years, and other methods (e.g., the loss development methods) provide more meaningful information for years with a greater level of maturity. Because each method has its own set of attributes, API does not rely exclusively upon a single method. Rather, API evaluates each of the methods for the different perspectives that they provide. Each method is applied in a consistent manner from period to period and the methods encompass a review of selected claims data, including claim and incident counts, average indemnity payments, and loss adjustment expenses.
As part of its evaluation, APIs outside consulting actuary develops a range of reserves it believes is reasonable. The upper end of the range generally reflects higher estimates of future loss and loss adjustment expenses while the lower end of the range generally reflects lower estimates of future loss and loss adjustment expenses. In general, the width of a range reflects the level of variability in the underlying projections. Therefore, in addition to the performance of the business itself, the financial condition, results of operations and cash flows are sensitive to reserve estimates and judgments. The range developed for APIs gross reserves before reinsurance for unpaid loss and loss adjustment expenses at December 31, 2006 was $71,242,000 on the low-end of the range to $110,093,000 on the high-end of the range with an actuarial point estimate of $88,988,000.
The results of the various methods, along with the supplementary statistical data regarding such factors as the current economic environment, are used by management to develop a best estimate based upon managements judgment and past experience. The process of selecting managements best estimate from the set of possible outcomes produced by the various actuarial methods is based upon the judgment of management and is not driven by formulaic determination. API selects a best estimate with due regard for the age, characteristics and volatility of the medical professional liability line of insurance, the volume of data available for review and past experience with respect to the accuracy of estimates. API utilizes and evaluates calculations contained in an actuarial study performed by its independent actuarial firm as an objective confirmation of the adequacy of its carried reserves. APIs best estimate may differ from the selected reserve estimate of its independent actuary because of differences in evaluating such things as the impact of historical experience, legal and regulatory changes and expectations about future claim results and trends. While APIs assessment may differ, its carried reserves remain within the actuarial range of the independent actuarys selected reserve estimate. The reserve opinions of APIs independent actuary for the years ended December 31, 2006 and 2005 have been filed with state insurance regulators along with APIs statutory financial statements.
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API has established its gross reserve before reinsurance for loss and loss adjustment expenses at $110,089,000 as of December 31, 2006 or what it believes to be the upper end of the reserve estimates, as projected by the actuarial review; however, there is no assurance that such reserves will ultimately prove adequate. API has established a position of reserving to the upper-end of the reserve estimate due to uncertainty related to the full financial impact of pre-tort and post-tort reform claims. Prior to the passage of tort reform legislation in 2003, API saw a significant increase in the number of cases filed prior to the effective date of the new tort law. While tort reform in Texas has been in effect since the latter part of 2003 and has lowered reported claim counts in 2004 through the first quarter of 2007 as compared to historical levels, a significant number of pre-tort reform claims remain outstanding and the ultimate severity patterns and payout trends for these claims are not fully known and developed. Furthermore, while the frequency of reported claims has decreased post-tort reform, API remains uncertain in regard to changes to severity patterns and payout trends post-tort reform due to the significant number of outstanding claims remaining for those years. As a result of the potential volatility and uncertainty of the remaining outstanding claims over two distinct and unique time periods, managements best estimate is near the high-end of the range of estimated outcomes.
API continually reviews and updates the data underlying the estimation of the loss and loss adjustment expense reserves and makes adjustments that it believes the emerging data warrant. Any adjustments to reserves that are considered necessary are reflected in the results of operations in the period the estimates are changed. If reserves ultimately prove to be too high, then the excess amount will be recognized as a reduction to loss and loss adjustment expenses in the current period of operations that the change in estimate is made. If reserves prove to be inadequate in the future, API would have to increase such reserves and incur a charge to earnings in the period that such reserves are increased, which could have a material adverse affect on its results of operations and financial condition. These specific risks described above, combined with the variability that is inherent in any reserve estimate, could result in significant positive or adverse deviation from APIs recorded net reserve amounts could positively or adversely impact APIs business, results of operations and cash flows.
Loss and loss adjustment expense represents the largest component of APIs expenses. In considering the potential sensitivity of the factors and assumptions underlying managements best estimate of loss and loss adjustment reserves, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a large average cost per claim. For example, at December 31, 2006, API had 4,712 policyholders, and in 2006 API paid a total of $9,684,000 in paid damages on 94 claims. Even a relatively small change in the number of claims expected to be paid (i.e. frequency) or a relatively small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, APIs financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, API has closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the average cost per claim, any change in the trends of key assumptions used in estimating the ultimate values such as legislative changes resulting in tort reform, claims handling procedures, economic inflation and other factors could result in a significant change in the reserve estimate.
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The following table reflects the activity in the liability for reserve for losses and loss adjustment expenses showing the changes for the twelve month periods beginning January 1, 2004 and ending December 31, 2006 and the three month period ended March 31, 2007 (in thousands):
March 31, 2007 |
2006 | 2005 | 2004 | ||||||||||
Reserve for losses and loss adjustment expensesJanuary 1 |
$ | 110,089 | $ | 95,372 | $ | 69,445 | $ | 63,713 | |||||
Less reinsurance recoverable on paid losses and unpaid losses |
28,491 | 27,850 | 11,203 | 14,980 | |||||||||
Net balanceJanuary 1 |
81,598 | 67,522 | 58,242 | 48,733 | |||||||||
Incurrednet of reinsurancerelated to: |
|||||||||||||
Current years |
10,886 | 43,431 | 28,261 | 29,305 | |||||||||
Prior years |
48 | (4,461 | ) | 15,715 | 19,350 | ||||||||
Net incurred |
10,934 | 38,970 | 43,976 | 48,655 | |||||||||
Paidnet of reinsurancerelated to: |
|||||||||||||
Current years |
620 | 4,820 | 4,062 | 4,181 | |||||||||
Prior years |
5,370 | 20,074 | 30,634 | 34,965 | |||||||||
Net paid |
5,990 | 24,894 | 34,696 | 39,146 | |||||||||
Net balanceMarch 31 and December 31 |
86,542 | 81,598 | 67,522 | 58,242 | |||||||||
Plus reinsurance recoverable on paid losses and unpaid losses |
29,685 | 28,491 | 27,850 | 11,203 | |||||||||
Reserve for losses and loss adjustment expensesMarch 31 and December 31 |
$ | 116,227 | $ | 110,089 | $ | 95,372 | $ | 69,445 | |||||
Incurrednet of reinsurance for the current year relates to incurred loss and loss adjustment expense related to premium earned in that period, also referred to as accident year. Incurrednet of reinsurance for the prior years represents the total net change in estimates charged or credited to earnings in the current year with respect to liabilities that originated and were established in prior years. As noted in the table above, for the period ending March 31, 2007, API increased its incurred loss and loss adjustment expense for the prior year unfavorable development by $48,000. For the year ended December 31, 2006, API decreased its incurred loss and loss adjustment expense for prior year development by $4,461,000. For the years ended December 31, 2005 and 2004, API increased its incurred loss and loss adjustment expense for prior year development by $15,715,000 and $19,350,000, respectively.
For the three months ended March 31, 2007, current accident year loss and loss adjustment expenses were $10,886,000. Due to an increase in the number of policyholders, the frequency of reported claims increased during the current quarter to 104 as compared to 92 for the three months ended March 31, 2006. API anticipates that the incurred average claim severity to be lower than the prior year comparable quarter. The effects of the 2003 tort reform in Texas on average claim severity are emerging favorably and resulting in improved claim development patterns. It has been over three years since the passage of reform and API has favorably settled a number of post-tort reform claims from the 2004, 2005 and 2006 report years. The lower settlement values on the post-tort reform years are more fully reflected in APIs estimates for reserves for loss and loss adjustment expenses. After an evaluation of open claims and trend assumptions, API recorded an increase of $48,000 for the three months ended March 31, 2007 for incurred losses and loss adjustment expenses for prior year development as a result of additional allocated loss adjustment expenses for prior year open claims.
During 2006, in consultation with APIs outside independent actuary, API recorded favorable development of $4,461,000 for the year ending December 31, 2006. The favorable development of prior-year claims in 2006 was primarily the result of 2004 and 2005 report year loss severity falling below expectations. Additionally, the total number of claims closed with indemnity for the 2004 and 2005 report years were developing favorably from prior estimates.
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During 2005, APIs current accident year reported claims were substantially lower; however, loss costs and legal expenses related to prior year claims continued to trend higher. API determined that the effect of tort reform not only increased the number of claims reported in 2003, but also increased the cost of litigating remaining open cases for other open prior accident years. As a result, during 2005, API continued to increase incurred loss and loss adjustment expense reserves related to prior accident years by $15,715,000. The net incurred increase in claim estimates related to prior years did not result in any direct accrual of additional premiums nor did it result in any additional ceded premiums during 2005 and 2004 under APIs variable premium reinsurance treaties.
During 2004, after evaluation of open claims and trend assumptions, API determined that the length of time needed to litigate 2003 pre-tort reform claims would continue to increase due to the potential financial impact of these claims in relation to post-tort reform claims. As a result, API increased the estimate for ultimate losses and loss adjustment expenses for claims incurred in 2003 and prior years by $19,350,000.
API attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherently uncertain process involving loss and loss adjustment expense reserve estimates, the final resolution of the ultimate liability may be different from that anticipated at the reporting date. Therefore, actual paid damages in the future may yield a materially different amount than currently reservedfavorable or unfavorable. While API believes that the estimates for loss and loss adjustment expense reserves are adequate as of March 31, 2007, there can be no assurance that its estimates will not change in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
The following table, known as the reserve development table, shows the development of the net liability for unpaid loss and loss adjustment expenses from 1996 through 2006. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year-ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. A (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
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The volatility of medical professional liability claim frequency and severity makes the prediction of the ultimate losses very difficult. Likewise, the long period of time necessary for medical professional liability claims to develop and be paid further complicates the reserving process.
As of and for the Year Ended December 31,
(in thousands)
1996 | 1997 | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | ||||||||||||||||||||||||||||||||||
Originally reported gross liability for unpaid losses and loss adjustment expenses |
$ | 75,501 | $ | 65,816 | $ | 67,971 | $ | 57,442 | $ | 67,751 | $ | 53,543 | $ | 54,186 | $ | 63,713 | $ | 69,445 | $ | 95,372 | $ | 110,089 | ||||||||||||||||||||||
Originally reported reinsurance paid & unpaid recoverable |
(21,145 | ) | (17,531 | ) | (25,624 | ) | (18,586 | ) | (25,720 | ) | (16,680 | ) | (17,923 | ) | (14,980 | ) | (11,203 | ) | (27,850 | ) | (28,491 | ) | ||||||||||||||||||||||
Originally reported net liability |
54,356 | 48,285 | 42,347 | 38,856 | 42,031 | 36,863 | 36,263 | 48,733 | 58,242 | 67,522 | 81,598 | |||||||||||||||||||||||||||||||||
Cumulative net paid as of: |
||||||||||||||||||||||||||||||||||||||||||||
One Year later |
22,879 | 24,299 | 24,988 | 21,805 | 27,998 | 23,360 | 31,779 | 34,965 | 30,634 | 20,074 | | |||||||||||||||||||||||||||||||||
Two Years later |
37,174 | 36,133 | 36,796 | 40,156 | 41,575 | 40,278 | 48,023 | 55,033 | 43,406 | | | |||||||||||||||||||||||||||||||||
Three Years later |
43,887 | 43,941 | 43,786 | 44,562 | 47,614 | 45,952 | 54,926 | 62,224 | | | | |||||||||||||||||||||||||||||||||
Four Years later |
45,261 | 46,950 | 44,904 | 46,015 | 50,520 | 48,503 | 57,389 | | | | | |||||||||||||||||||||||||||||||||
Five Years later |
46,741 | 46,825 | 45,626 | 47,670 | 51,090 | 49,417 | | | | | | |||||||||||||||||||||||||||||||||
Six Years later |
46,964 | 47,017 | 46,786 | 47,905 | 51,674 | | | | | | | |||||||||||||||||||||||||||||||||
Seven Years later |
47,332 | 47,784 | 46,903 | 48,520 | | | | | | | | |||||||||||||||||||||||||||||||||
Eight Years later |
47,998 | 47,745 | 47,487 | | | | | | | | | |||||||||||||||||||||||||||||||||
Nine Years later |
47,785 | 48,025 | | | | | | | | | | |||||||||||||||||||||||||||||||||
Ten Years later |
47,781 | | | | | | | | | | | |||||||||||||||||||||||||||||||||
Re-estimated net liability as of: |
||||||||||||||||||||||||||||||||||||||||||||
End of Year |
54,356 | 48,285 | 42,347 | 38,856 | 42,031 | 36,863 | 36,263 | 48,733 | 58,242 | 67,522 | 81,598 | |||||||||||||||||||||||||||||||||
One Year later |
45,738 | 46,166 | 42,837 | 37,248 | 39,708 | 42,155 | 49,073 | 68,083 | 73,957 | 63,061 | | |||||||||||||||||||||||||||||||||
Two Years later |
46,135 | 44,687 | 43,677 | 41,837 | 48,411 | 45,826 | 61,294 | 79,041 | 69,525 | | | |||||||||||||||||||||||||||||||||
Three Years later |
47,250 | 46,069 | 44,636 | 47,540 | 50,926 | 54,212 | 64,379 | 81,888 | | | | |||||||||||||||||||||||||||||||||
Four Years later |
46,681 | 47,804 | 46,880 | 48,214 | 55,846 | 55,618 | 66,557 | | | | | |||||||||||||||||||||||||||||||||
Five Years later |
47,507 | 48,130 | 47,420 | 51,101 | 56,163 | 54,762 | | | | | | |||||||||||||||||||||||||||||||||
Six Years later |
47,786 | 48,541 | 49,604 | 51,064 | 55,236 | | | | | | | |||||||||||||||||||||||||||||||||
Seven Years later |
48,491 | 49,864 | 49,626 | 50,551 | | | | | | | | |||||||||||||||||||||||||||||||||
Eight Years later |
49,307 | 49,388 | 48,873 | | | | | | | | | |||||||||||||||||||||||||||||||||
Nine Years later |
48,994 | 48,773 | | | | | | | | | | |||||||||||||||||||||||||||||||||
Ten Years later |
48,439 | | | | | | | | | | | |||||||||||||||||||||||||||||||||
Net cumulative redundancy (deficiency) |
$ | 5,917 | $ | (488 | ) | $ | (6,526 | ) | $ | (11,695 | ) | $ | (13,205 | ) | $ | (17,899 | ) | $ | (30,294 | ) | $ | (33,155 | ) | $ | (11,283 | ) | $ | 4,461 | $ | |
In evaluating the information in the table above, it should be noted that each column includes the effects of changes in amounts for prior periods. The table does not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
The variation in loss development since 2003 is primarily driven by tort reform enacted in Texas in September 2003. Tort reform capped certain non-economic damages that can be awarded in medical professional liability lawsuits and reduced the losses associated with post-tort reform claims.
Reinsurance Premiums Ceded. API enters into reinsurance agreements whereby other insurance entities agree to assume a portion of the risk associated with the policies issued by API. In return, API agrees to pay a
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premium to the reinsurers. API utilizes reinsurance to provide for greater diversification of business, which allows management to control exposure to potential losses arising from large risks, and allows API to have additional capacity for growth. API remains responsible for the ultimate risk on its policies and would be responsible for losses and loss adjustment expenses should a reinsurer fail to pay its obligations. Reinsurance agreements are also subject to risk transfer analysis in order to be recognized as traditional reinsurance for GAAP or statutory accounting purposes. Risk transfer standards require that (a) the reinsurer assumes significant insurance risk (underwriting and timing risk) under the reinsured portions of the underlying insurance agreements; and (b) it is reasonably possible that the reinsurer may realize a significant loss from the transaction. Whether a reinsurance agreement involves risk transfer is determined by API, with assistance from its outside consulting actuaries, utilizing a comprehensive set of standards. API believes that all of its reinsurance agreements contain the appropriate risk transfer requirements.
Under APIs primary medical professional liability reinsurance contract or excess of loss treaty, certain premiums are ceded to other insurance companies under the terms of the reinsurance agreement. The excess of loss treaty provides coverage for losses in excess of APIs retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The 2006 reinsurance contract provides for these same terms with API retaining 10% of the risk above the aforementioned $250,000 and $350,000 retention levels. The 2007 reinsurance contract provides for the same terms with API retaining 20% of the risk above the $250,000 and $350,000 retention levels. The reinsurance contracts for 2002 through 2007 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contracts are subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
To the extent that estimates for unpaid losses and loss adjustment expenses change, the amount of variable reinsurance premiums may also change. The ceded premium estimates are based upon managements estimates of ultimate losses and loss adjustment expenses and the portion of those losses and loss adjustment expenses that are allocable to reinsurers under the terms of the related reinsurance agreements. Given the uncertainty of the ultimate amounts of losses and loss adjustment expenses, these estimates may vary significantly from the ultimate outcome. In addition to the in-depth review of reserves for unpaid losses and loss adjustment expenses, on a semi-annual basis, API also has its outside consulting actuary review development in the reinsurance layer or excess of $250,000 retention for each open variable premium treaty year. Management reviews these estimates and any adjustments necessary are reflected in the period in which the change in estimate is determined. Adjustment to the premiums ceded could have a material effect on APIs results of operations for the period in which the change is made.
In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis give rise to a balance sheet asset classified as Other amounts receivable under reinsurance contracts or a balance sheet liability classified as Funds held under reinsurance treaties. Furthermore, each retrospective treaty requires a 24- or 36-month holding period before any premium adjustments or cash can be returned or paid. During the quarter ended March 31, 2007, API received a net payment of $13,816,000 from its reinsurers at expiration of the 36-month holding period for the 2003 treaty year and the 24-month holding period for the 2004 treaty, which included a premium adjustment to the reinsurers of $469,000 for the 2002 treaty year. These reinsurance proceeds represent an initial reimbursement of excess reinsurance premiums paid on a provisional basis for the 2003 and 2004 treaty years. The ultimate settlement amount will not be determined until all losses have been settled under the respective treaties. As of March 31, 2007, API had recorded a balance sheet asset, Other amounts receivable under reinsurance contracts of $1,372,000 and a balance sheet liability, Funds held under reinsurance treaties of $11,112,000, which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2006 treaty years as compared to the amounts paid on a provisional basis.
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The effect of reinsurance on premiums written and earned is as follows (in thousands):
Three Months Ended March 31, 2007 |
2006 | 2005 | 2004 | |||||||||||||||||||||||||||||
Written | Earned | Written | Earned | Written | Earned | Written | Earned | |||||||||||||||||||||||||
Gross premiums and maintenance fees including converted surplus deposits |
$ | 15,466 | $ | 18,736 | $ | 74,833 | $ | 75,746 | $ | 79,301 | $ | 76,948 | $ | 84,571 | $ | 77,027 | ||||||||||||||||
Cededcurrent year |
(2,407 | ) | (2,425 | ) | (12,452 | ) | (12,630 | ) | (12,871 | ) | (12,751 | ) | (14,343 | ) | (13,876 | ) | ||||||||||||||||
Cededprior year |
| | 7,743 | 7,743 | (14 | ) | (14 | ) | 1,465 | 1,465 | ||||||||||||||||||||||
Premiums ceded |
$ | (2,407 | ) | $ | (2,425 | ) | $ | (4,709 | ) | $ | (4,887 | ) | $ | (12,885 | ) | $ | (12,765 | ) | $ | (12,878 | ) | $ | (12,411 | ) | ||||||||
Net premiums and maintenance fees earned |
$ | 13,059 | $ | 16,311 | $ | 70,124 | $ | 70,859 | $ | 66,416 | $ | 64,183 | $ | 71,693 | $ | 64,616 | ||||||||||||||||
For the year ended December 31, 2006, API recorded favorable net development to ceded premiums of $7,743,000 related to prior variable premium reinsurance treaties as a result of lower estimated ultimate loss and loss adjustment expenses for treaty years 2002 through 2005. For the year ended December 31, 2005, API recorded net unfavorable development to ceded premiums of $14,000 due to unfavorable development as a result of higher estimated ultimate loss and loss adjustment expenses of $2,562,000 for the 2003 treaty year offset by $236,000 and $2,312,000 of favorable development for the 2002 and 2004 treaty years, respectively. For the year ended December 31, 2004, API recorded net favorable development of $1,465,000 to ceded premiums primarily due to favorable trends in excess loss layers for the 2002 and 2003 years as a result of lower estimated ultimate loss and loss adjustment expenses. API did not record any favorable or unfavorable development for the quarter ended March 31, 2007.
Reinsurance Recoverables. Ceded reserves for loss and loss adjustment expenses are recorded as reinsurance recoverables. Reinsurance recoverables are the estimated amount of future loss payments that will be recovered from reinsurers, and represent the portion of losses incurred during the period that are estimated to be allocable to reinsurers.
There are several factors that can directly affect the ability to accurately forecast the reinsurance recoverables. Many of the factors discussed above related to the sensitivities of forecasting total loss and loss adjustment expense reserves also apply when analyzing reinsurance recoverables. Since API cedes excess losses above $250,000 on individual claims and $350,000 on multiple insured claims, the trends related to severity significantly affect this estimate. Current individual claims severity can be above or fall below APIs retention level over the period it takes to resolve a claim. Furthermore, tort reform in Texas has been in effect since the latter part of 2003 and has lowered claim counts but the trends of severity payouts are only beginning to emerge.
Similar to the estimate for reserves, due to the long-tailed nature of the medical professional liability line of insurance, relatively small changes in the actuarial assumptions for trends, inflation, severity, frequency for projected ultimate loss and loss adjustment expense reserves can have a greater impact on the recorded balance for reinsurance recoverables than with most other property and casualty insurance lines. While API believes that its estimate for ultimate projected losses related to loss and loss adjustment expense is adequate based on reported and open claim counts, there can be no assurance that additional significant reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
Reinsurance contracts do not relieve API from its obligations to policyholders. API continually monitors its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Any amount found to be
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uncollectible is written off in the period in which the uncollectible amount is identified. API requires letters of credit from any reinsurance company that does not meet certain regulatory requirements, and/or credit ratings. As of March 31, 2007, all of APIs reinsurance contracts were with companies in strong financial condition, and management believes there is not a need to establish an allowance for uncollectible reinsurance recoverable. API has not experienced any material problems collecting from its reinsurers.
Unsecured reinsurance recoverables at March 31, 2007 and December 31, 2006, that exceeded 10% of total reinsurance paid and unpaid loss and loss adjustment expenses are summarized as follows (in thousands):
Company Name |
March 31, 2007 |
December 31, 2006 | ||||
Transatlantic Reinsurance |
$ | 5,214 | $ | 4,550 | ||
Swiss Reinsurance |
17,005 | 16,897 |
Both Transatlantic Reinsurance and Swiss Reinsurance are A.M. Best rated A+ (Superior).
Deferred Policy Acquisition Costs. The costs of acquiring and renewing insurance business that vary with and are directly related to the production of such business are deferred and amortized ratably over the period the related premiums are earned. Such costs include commissions, premium taxes and certain underwriting and policy issuance costs. Deferred acquisition costs are recorded net of ceding commissions. 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 in the period the determination is made.
Death, Disability and Retirement Reserves. API has established a death, disability and retirement reserve for policyholders, which is intended to set aside a portion of the policy premium to account for the coverage provided for the extended reporting period or tail coverage offered by API upon the death and/or disability and/or retirement of a policyholder which is provided at no additional cost to the policyholder. The death, disability and retirement reserve is included in unearned premiums.
Refundable Deposits. API was initially capitalized by contributions from its subscribers. While no new deposits have been required since 1992, API had an obligation to repay these amounts and they were classified as a liability. As such, API has adopted SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Additionally, see Note 8 of the audited financial statements included herein for more complete information. Effective with the acquisition of API, the remaining balances of refundable deposits were extinguished in exchange for our Series A redeemable preferred stock.
Revenue Recognition. API recognizes revenue in accordance with SFAS No. 60, Accounting and Reporting of Insurance Enterprises. API issues policies written on a claims-made basis. A claims-made policy provides coverage for claims reported during the policy year. API charges both a base premium and a premium maintenance fee. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro rata basis over the term of the policy. Premium maintenance fees are charged to offset the costs incurred by API to issue and maintain policies. Unearned premiums and maintenance fees are determined on a monthly pro rata basis. Upon termination of coverage, policyholders may purchase an extended reporting period (tail) endorsement for additional periods of time. These extended reporting period coverage endorsement premiums are earned when written.
Income Taxes. API computes income taxes utilizing the asset and liability method. API recognizes current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to
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be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. API has not established a valuation allowance because it believes it is more likely than not its deferred tax assets will be fully recovered.
Results of Operations of the Company
With the acquisition of API on April 1, 2007, we anticipate that our long-term consolidated revenue and earnings will be predominately derived from medical professional liability insurance provided through our Insurance Services segment. The historical results of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations such as personnel expenses, rent, office expenses and technology costs. As a result of our acquisition of API, these management fees will no longer affect the Companys consolidated results of operations.
The results of operations discussed below regarding the Company refer to historical financial and operating data of American Physicians Service Group, Inc. prior to the acquisition of API on April 1, 2007. For a discussion of the results of operations of API prior to the acquisition by the Company, please see Pre-Acquisition Results of Operations of API below, starting on page 62. For a better understanding of the Companys financial results had we acquired API before April 1, 2007, please refer to the unaudited pro forma condensed consolidated financial statements included elsewhere herein and related notes thereto.
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The following table sets forth selected historical financial and operating data for the Company. The income statement data set forth below for each of the years in the three-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006, 2005 and 2004 are derived from our consolidated audited financial statements included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto. The income statement data for the three months ended March 31, 2007 and 2006, and the balance sheet data as of March 31, 2007 and 2006, are derived from our consolidated unaudited financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All information is presented in accordance with GAAP, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of SFAS No. 123(R). Actual financial results through March 31, 2007 may not be indicative of future financial performance.
Three Months Ended March 31, (unaudited) |
Year Ended December 31, | ||||||||||||||||||
2007 | 2006 | 2006 | 2005 | 2004 | |||||||||||||||
(in thousands, except per share data) | |||||||||||||||||||
Selected Income Statement Data: |
|||||||||||||||||||
Revenues: |
|||||||||||||||||||
Insurance services |
$ | 3,657 | $ | 3,655 | $ | 15,555 | $ | 15,514 | $ | 15,316 | |||||||||
Financial services |
5,216 | 3,578 | 16,805 | 18,459 | 16,705 | ||||||||||||||
Total revenues |
8,873 | 7,233 | 32,360 | 33,973 | 32,021 | ||||||||||||||
Expenses: |
|||||||||||||||||||
Insurance services |
3,823 | 2,754 | 11,262 | 10,262 | 9,968 | ||||||||||||||
Financial services |
4,437 | 3,285 | 15,145 | 16,263 | 14,538 | ||||||||||||||
General and administrative |
777 | 518 | 2,128 | 2,737 | 2,227 | ||||||||||||||
Gain on sale of assets |
(5 | ) | | (29 | ) | (134 | ) | (56 | ) | ||||||||||
Total expenses |
9,032 | 6,557 | 28,506 | 29,128 | 26,677 | ||||||||||||||
Gain on investments |
84 | 7 | 259 | 3,160 | 245 | ||||||||||||||
Loss on impairment of investment |
(423 | ) | | (19 | ) | (217 | ) | (2,567 | ) | ||||||||||
Gain on extinguishment of debt |
| | | 24 | 75 | ||||||||||||||
Interest income |
334 | 197 | 915 | 587 | 365 | ||||||||||||||
Other income |
19 | 6 | 49 | 124 | 15 | ||||||||||||||
Net income (loss) |
$ | (95 | ) | $ | 562 | $ | 3,194 | $ | 5,460 | $ | 2,152 | ||||||||
Per share amounts: |
|||||||||||||||||||
Basic: Net income (loss) |
$ | (0.03 | ) | $ | 0.20 | $ | 1.15 | $ | 2.03 | $ | 0.85 | ||||||||
Diluted: Net income (loss) |
$ | (0.03 | ) | $ | 0.19 | $ | 1.09 | $ | 1.86 | $ | 0.76 | ||||||||
Diluted weighted average shares outstanding |
2,822 | 2,909 | 2,933 | 2,931 | 2,838 | ||||||||||||||
Cash dividends |
| | $ | 0.30 | $ | 0.25 | $ | 0.20 | |||||||||||
Book value per share |
$ | 10.81 | $ | 10.16 | $ | 10.49 | $ | 9.95 | $ | 9.23 | |||||||||
Selected Balance Sheet Data: |
|||||||||||||||||||
Total assets |
$ | 41,606 | $ | 33,149 | $ | 36,276 | $ | 33,505 | $ | 30,443 | |||||||||
Long-term obligations |
| | | | 1,133 | ||||||||||||||
Total liabilities |
10,668 | 5,147 | 6,687 | 5,783 | 6,229 | ||||||||||||||
Minority interests |
21 | 16 | 21 | 15 | 1 | ||||||||||||||
Total Shareholders Equity |
$ | 30,917 | $ | 27,986 | $ | 29,568 | $ | 27,707 | $ | 24,213 |
Overview and Business Outlook for the Company
Insurance Services revenues for the three months ended March 31, 2007 generally were level with revenues recorded for the same period in 2006. Prior to our acquisition of API, our insurance segment was greatly affected by the profitability of API, which we managed as the attorney-in-fact through a management agreement. The management
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agreement obligated API to pay management fees to us based on APIs earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of APIs earned premiums. In addition, any pre-tax profits of API were shared equally with us (profit sharing) so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, our management agreement with API was terminated and replaced with an intercompany management agreement. Our consolidated results of operations are no longer affected by management fees from API; rather, our results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
Insurance Services operating expenses were higher in the three months ended March 31, 2007 than the three months ended March 31, 2006, primarily due to an expense recognized for the fully-vested stock options awarded to the former board members of API for services on the new advisory board. The advisory board was established to provide insight into the physician community, which is important to us as we concentrate our business focus on medical professional liability insurance. Also, we anticipate that professional fees will be higher in future periods as a result of the development of compliance programs related to Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404).
APS Financial, the broker-dealer division of our Financial Services segment, saw growth in commission revenue in the three months ended March 31, 2007 compared to the same period in 2006, due to an increase in the general trading activity of debt securities as well as some specific trading that resulted from customer profit taking of prior positions, while we also saw a decrease in investment banking and bank debt and trade claim transactions, which was largely the result from timing of the closing of various investment banking placements.
For commission revenue generation, bullish, unstable markets provide us with the most opportunity. Conversely, stable, bearish markets pose the greatest difficulty in generating income. Uncertainty in world, political and economic events can also be an obstacle to revenue generation. Investors may take a wait-and-see attitude should uncertainty exist.
Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006 for the Company
Revenues from operations increased $1,640,000 (23%) to $8,873,000 from $7,233,000 in the three months ended March 31, 2007 compared to the same period in 2006. Our operating income decreased $835,000 (124%) to an operating loss of $159,000 from an operating profit of $676,000 for the three months ended March 31, 2007 compared to the same period in 2006. Our net income decreased $657,000 (117%) to a net loss of $95,000 from a profit of $562,000 for the three months ended March 31, 2007, compared to the same period in 2006. Lastly, our diluted net income per share decreased $0.22 to a net loss of $0.03 per share from a profit of $0.19 per share in the current year three months compared to the same period in 2006. The reasons for these changes are described below.
Insurance Services Revenues. Total revenues from our Insurance Services segment were virtually unchanged in the three month period ended March 31, 2007 compared to the same period in 2006, increasing approximately $2,000 to $3,657,000 from $3,655,000. The individual components of total revenues did, however, vary significantly. As a result of our acquisition of API, effective April 1, 2007, we earned and recorded contingent management fees through March 31, 2007. Prior to the acquisition, we historically recognized a full years contingent management fee in the fourth quarter of each year for this profit sharing component of management fees. Because of the acquisition, however, we recorded approximately $496,000 of fee revenue for the three months ended March 31, 2007 compared to zero during the same period in 2006. Since the management contract ended March 31, 2007, we recognized the quarters profit sharing in March, based on our ability to fully determine the profit sharing base.
Basic management fees were down $138,000 (6%) to $2,233,000 from $2,371,000 in the three months ended March 31, 2007 compared to the same period in 2006 as a result of $1,690,000 (8%) lower earned premiums for API over this same period. Earned premiums and maintenance fees before reinsurance were
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$18,718,000 for the three months ended March 31, 2007 compared to $20,408,000 for the same period in 2006. The decrease in earned premiums for API was the result of lower gross premiums and maintenance fees written of $4,649,000 (23%) to $15,466,000 from $20,115,000 for the three months ended March 31, 2007 as compared to the same period in 2006. This decrease in written premiums was primarily due to increased competition and premium rate decreases. Of the $4,649,000 in lower written premiums for the three months ended March 31, 2007 as compared to the same period in 2006, new business written premiums for API decreased $3,641,000 (91%) and renewal premiums decreased $405,000 (3%). The decline in renewal premiums was primarily the result of continued rate pressure created by increased competition, which caused renewal rates to decline an average of 18% for the three months ended March 31, 2007 as compared to the same period in 2006. While rate decreases and increased competition continue to create downward pressure on written and earned premiums for API, overall policyholder headcount increased by 1.5% to 4,781 from 4,712 for the three months ended March 31, 2007, driven predominately by policyholder retention on renewal business which was in excess of 90% and the addition of new business in the three months ended March 31, 2007. Pass through commission income was down $288,000 (23%) to $989,000 from $1,277,000 in the three months ended March 31, 2007 compared to the same period in 2006 as a result of the above discussed decrease in premiums written for API. As noted in the following paragraph, commissions paid to third party independent agents decreased by an equivalent amount, resulting in no impact on net income.
Insurance Services Expenses. Insurance Services expenses increased $1,069,000 (39%) to $3,823,000 from $2,754,000 in the three months ended March 31, 2007 compared to the same period in 2006. The three months ended March 31, 2007 increase was primarily due to an expense recognized for the fully-vested stock options awarded to the former board members of API pursuant to the terms of our acquisition of API, and equity awards to employees who were instrumental in accomplishing the acquisition. The total cost recognized during the three months ended March 31, 2007 for these equity awards amounted to approximately $1,200,000. In addition, payroll and professional fees were higher in the first quarter of 2007 compared to the same period in 2006. Payroll increased $89,000 (11%) to $925,000 from $836,000 due to regular annual employee merit raises as well as the hiring of additional personnel. Professional fees were $65,000 (107%) higher in 2007 to $126,000 from $61,000 due primarily to consulting fees related to the selection of new policy and claims software for our newly acquired subsidiary. Partially offsetting these increases is the previously discussed decrease in commissions paid to third party independent agents. These pass through commission expenses declined $288,000 (23%) to $989,000 from $1,277,000 during the first quarter of 2007 compared to the same period in 2006.
Financial Services Revenues. Our Financial Services revenue increased $1,638,000 (46%) to $5,216,000 from $3,578,000 in the first three months of 2007 compared to the same period in 2006. APS Financial, our broker-dealer subsidiary, derives most of its revenue from transactions in the fixed-income market, in both investment and non-investment grade securities. Commission revenue at APS Financial was up by $2,013,100 (78%) to $4,595,000 from $2,582,000 reflecting an increase in the general trading activity of debt securities as well as some specific trading that resulted from customer profit taking of prior positions. These broker-dealer commission revenues were up despite the closure of our Houston office which had accounted for $470,000 in commissions in the first quarter of 2006. This revenue gain was partially offset by an aggregate $375,000 (38%) decrease in revenues, to $621,000 from $996,000, from other operations, including investment banking and bank debt and trade claim transactions, which was largely the result from timing of the closing of various investment banking placements. The environment for trading in both investment grade and non-investment grade securities remains difficult due to various factors including low level of interest rates combined with low volatility, a flat treasury curve, low corporate default rates and price transparency.
Financial Services Expenses. Our Financial Services expenses increased $1,152,000 (35%) to $4,437,000 from $3,285,000 in the three months ended March 31, 2007 compared to the same period in 2006. The primary reason for the current year increase is a $1,002,000 (51%) increase to $2,985,000 from $1,983,000 in commission expense in the current year three month period compared to the same period in 2006 resulting from commissions paid on increased commission revenues earned. In addition, incentive compensation expense increased $171,000 (346%) to $221,000 from $50,000 in the three months ended March 31, 2007 as a result of an
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$840,000 (257%) increase to $1,166,000 from $326,000 in pre-tax earnings net of incentive compensation expense. Finally, stock option expense in the three months ended March 31, 2007, totaled $46,000 in 2007 compared to zero in the same three months in 2006. Partially offsetting these increases in expenses are decreases in payroll, benefits and rent. Payroll was down $55,000 (10%) to $483,000 from $537,000, employee benefits was down $38,000 (13%) to $256,000 from $295,000 and rent was down $22,000 (40%) to $33,000 from $56,000 in the three months ended March 31, 2007 compared to the same period in 2006 as a result of the decision made in the third quarter of 2006 to close the Houston office and consolidate trading into our Austin, Texas office.
General and Administrative Expense. General and administrative expenses increased $259,000 (50%) to $777,000 from $518,000 in the three month period ended March 31, 2007 compared to the same period in 2006. The increase is due in part to deferred compensation awards resulting primarily from the recruitment and hiring during the period of our new company president and chief operating officer, Timothy LaFrey. The cost associated with these deferred shares in the three months ended March 31, 2007, totaled $162,000. In addition, board fees increased $28,000 (69%) to $70,000 from $42,000 in the three months ended March 31, 2007, as a result of additional board meetings held in 2007 to primarily discuss and prepare for our acquisition of API. Lastly, professional fees increased $19,000 (172%) to $30,000 from $11,000 in the three months ended March 31, 2007, as a result of accruals for the independent audit of our internal controls to comply with the Sarbanes-Oxley Act of 2002.
Gain on Investments. The gain in 2007 primarily represents the receipt of cash in payment for a note that had been written off as uncollectible in 2005. In addition, a gain of approximately $9,000 was recorded resulting from the sale of shares of available-for-sale equity securities. The gain in 2006 represents a small gain on the sale of an available-for-sale fixed-income security.
Loss on Impairment of Investment. The loss recorded in the first quarter of 2007 represents a write-down of our investment in FIC common stock, having previously resolved that declines in FICs stock price will be considered to be other than temporary. Our policy in regards to our investment in FIC is that we record pre-tax charges to earnings should the common stock price on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. In the first three months of 2007, that charge totaled approximately $423,000, calculated by multiplying the total number of FIC shares we own (385,000) by the change in our adjusted basis in FIC common stock at December 31, 2006 ($7.60 per share) and its fair market value at March 31, 2007 ($6.50 per share).
Interest Income. Our interest income increased $137,000 (70%) to $334,000 from $197,000 in the three month period ended March 31, 2007 compared to the same period in 2006. The current year three month increase was primarily due to higher rates as well as a much higher balance of interest-bearing fixed-income securities. At March 31, 2007 there was a balance in investment securities held of $17,600,000 compared to a balance of $14,500,000 held at March 31, 2006. In addition, in the three months ended March 31, 2007, we received interest on a loan that had been defaulted upon during 2006 totaling $23,900.
Other Income. Our other income increased $13,000 (217%) to $19,000 from $6,000 for the three month period ended March 31, 2007 compared to the same period in 2006. The increase in the current year three month period is due in part to small inventory gains on securities held at APS Financial in 2007 compared to small inventory losses in 2006.
Minority Interest. For each of the three months ended March 31, 2007 and 2006, minority interest represented a 3% interest in Asset Management, a subsidiary within our Financial Services segment, owned by key individuals within Asset Management.
Cash Flows. Our total cash and cash equivalents balance at March 31, 2007 increased $585,000 (14%) to $4,827,000 from $4,242,000 in the current year as cash provided by operating and financing activities more than offset net cash used in investing activities. Our cash flows provided from operating activities totaled $1,595,000
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for the three months ended March 31, 2007 due in part to cash received from API for 2006 profit sharing ($2,000,000) that was recorded in 2006. Partially offsetting this was cash paid in the three months ended March 31, 2007 for incentive compensation earned and accrued in 2006 ($2,200,000). Our cash flows used in investing activities totaled $1,124,000 in the first three months of 2007 primarily as a result of purchases of available-for-sale fixed-income securities in excess of proceeds from their sale. Our cash provided by financing activities totaled $114,000 in the first quarter of 2007 primarily as a result of cash received from the exercise of stock options.
2006 Compared to 2005 for the Company
Revenues from operations decreased $1,613,000 (5%) to $32,360,000 from $33,973,000 in the year ended December 31, 2006 compared to 2005. Our operating income decreased $991,000 (20%) to $3,854,000 from $4,845,000 in 2006 compared to 2005. Our net income decreased $2,266,000 (42%) to $3,194,000 from $5,460,000 in 2006 compared to 2005. Lastly, our diluted net income per share decreased $0.77 (41%) to $1.09 from $1.86 in 2006 compared to 2005. The reasons for these changes are described below.
Insurance Services Revenues. Total revenues from our Insurance Services segment increased $41,000 (0%) to $15,555,000 from $15,514,000 for the year ended December 31, 2006 compared to 2005. The current year increase in revenues is mainly attributable to higher pass through commissions which increased by $270,000 (6%) to $4,646,000 from $4,376,000 in 2006 as commission rates and premiums written through agents for new business at API remained higher in 2006. Third party agents were paid higher effective commission rates as a result of their writing more new business and in order to increase market share. As noted in the following paragraph, commissions paid to third party independent agents increased by an equivalent amount, resulting in no impact on net income. Partially offsetting this increase was a decrease in management fee revenue of $67,000 (1%) to $8,971,000 from $9,038,000, the result of lower earned premiums and maintenance fees before reinsurance at API of $1,499,000 (2%) to $75,568,000 for the year ended December 31, 2006 from $77,067,000 for the year ended December 31, 2005, due to rate decreases implemented in the latter part of 2005. This resulted in lower gross premiums and maintenance fees written of $4,468,000 (6%) to $74,833,000 for the year ended December 31, 2006 from $79,301,000 for the year ended December 31, 2005. While planned rate decreases lowered written premiums, policyholder retention remained strong at greater than 90% for API. In addition, risk management fees decreased $95,000 (47%) to $109,000 from $204,000 for the year ended December 31, 2006 compared to 2005 as a result of fewer renewals requiring these services and the discontinuation of a high-risk management program at the end of 2005. This decrease in risk management fees is the result of two key factors: (1) fees are lower due to an improved claims environment following tort reform legislation enacted in 2003, resulting in fewer new business and renewal accounts being placed into the risk management program and thus being required to pay for these services; and (2) risk management services continue to be performed, but due to increased competition we have occasionally provided these services at no charge.
Insurance Services Expenses. Insurance services expenses increased $1,000,000 (10%) to $11,262,000 from $10,262,000 for the year ended December 31, 2006 compared to 2005. Payroll expense increased $291,000 (9%) to $3,448,000 from $3,157,000 in 2006 compared to 2005 due in part to merit increases, the addition of new managerial positions, additional staff positions for business development and physician services departments and expensing stock options as required by SFAS No. 123(R). Options expense totaled $144,000 in 2006, the first year that we expensed stock options. Professional fees increased $165,000 (65%) to $419,000 from $254,000 in 2006 compared to 2005 due primarily to consulting costs incurred in the analysis of new policy and claims software. Pass through commissions expense increased $270,000 (6%) in 2006 compared to 2005 due to the above-mentioned increase in commissions paid to third party independent agents. Lastly, advertising expense increased $65,000 (72%) to $155,000 from $90,000 in 2006 compared to 2005 due to consulting costs associated with increased marketing efforts.
Financial Services Revenues. Financial Services revenues decreased $1,654,000 (9%) to $16,805,000 from $18,459,000 in 2006 compared to 2005. This decrease was primarily due to lower revenue derived from
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commissions earned at our broker-dealer, APS Financial. Commission income, mostly generated from transactions in the investment grade and non-investment grade fixed-income market, was down $5,420,000 (33%) to $10,990,000 from $16,410,000 in 2006 compared to 2005. Going into 2006, the Federal Reserve had raised short-term rates 17 times for a total of 425 basis points since mid 2004, and then held rates steady throughout 2006. The resulting flat to inverted yield curve, in conjunction with lack of volatility throughout the year, resulted in generally less customer activity and trading volumes in investment grade bonds. As a result of these depressed trading conditions, APS Financial shut down its Houston branch office in the third quarter of 2006 and consolidated its trading and sales activities in its Austin office. Regarding its non-investment grade trading, APS Financial has also realized lower trading volumes in the high yield market, due to narrow interest rate spreads. The narrow spreads resulted from a corporate market experiencing historically low default rates and lower volatility. Offsetting somewhat the lower level of securities trading revenues were revenues earned from our investment banking and distressed debt/trade claim trading operations, which contributed an aggregate increase of $3,763,000 (201%) to $5,638,000 from $1,875,000 in 2006 compared to 2005.
Financial Services Expenses. Financial services expenses decreased $1,118,000 (7%) to $15,145,000 from $16,263,000 in 2006 compared to 2005. Reflecting the above-mentioned lower commission revenue, commission expense, which includes commissions from secondary market trading, as well as placement fees for investment banking and referral fees for bank debt trading, were down $1,512,000 (14%) to $9,391,000 from $10,903,000 in 2006 compared to 2005. Partially offsetting this decrease in 2006 expenses was an increase in payroll which was up $195,000 (11%) to $2,013,000 from $1,818,000 in 2006 due largely to the hiring of additional personnel in the investment banking and bank debt trading areas as the firm continued to ramp up these business efforts. Also adding to the payroll variance was an increase in performance-related forgivable loans granted to a high-producing broker and which are expensed upon his continued employment with us. In addition, options expense totaled $44,000 in 2006, the first year that we expensed stock options.
General and Administrative Expense. Our general and administrative expenses decreased $609,000 (22%) to $2,128,000 from $2,737,000 in 2006 compared to 2005. The current year decrease is primarily due to lower incentive compensation expense. Incentive compensation, a formula driven expense calculated in part on net earnings, decreased $442,000 (42%) to $613,000 from $1,055,000 due to much lower investment gains in 2006 compared to 2005. In addition, salaries expense was $84,000 (11%) lower to $708,000 from $792,000 in 2006 as a result of a severance payment in 2005 to a former employee, Duane Boyd, who has since been retained as a tax consultant. Legal and professional fees declined in 2006 by $128,000 (46%) to $153,000 from $281,000 as costs associated with internal controls disclosures and procedures under SOX 404, compliance was minimal in 2006 compared to 2005 when we were ramping up our compliance efforts. With the uncertainty as to what, if any, relief was to be granted to non-accelerated filers like us, we slowed our expenditures in an attempt to control SOX 404 compliance costs. In particular, we did not retain the outside SOX 404 consultants we employed during 2005 and have concentrated instead on internal compliance efforts. Our SOX 404 compliance costs in 2007 can be expected to increase over 2006, as we will hire a director of internal audit to complete our SOX compliance efforts. Partially offsetting these decreases was stock option expense of $45,000 in 2006, the first year that such expenses were charged.
Gain on Sale of Assets. In 2006, we recognized $422,000 of deferred gain related to the November 2001 sale and subsequent leaseback of real estate to Prime Medical Services, Inc. (now HealthTronics, Inc.). Due to our continuing involvement in the property, we deferred recognizing approximately $2,400,000 of the approximately $5,100,000 gain and recognized it in earnings, as a reduction of rent expense, monthly through September 2006. As of September 30, 2006, no more of these deferred gains remain to be recognized. In addition, 15% of the gain ($760,000) related to our then 15% ownership in the purchaser, was deferred. As our ownership percentage in HealthTronics, Inc. declines through our sales of HealthTronics, Inc. common stock, we recognize these gains proportionately to the reduction of our interest in HealthTronics, Inc. In 2006, we recognized approximately $30,000 of these deferred gains as a result of HealthTronics, Inc. common stock sold in the year. As of December 31, 2006, there remained a balance of approximately $17,000 to be recognized in future periods.
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Gain on Investments. Gains on investments decreased $2,901,000 (92%) to $259,000 from $3,160,000 in 2006 compared to 2005 due to the sale of a much larger number of available-for-sale equity securities in 2005 compared to sales in 2006. Sales of these securities are down in 2006 as a result of fewer shares held by us and a decline in their market price. Partially decreasing the 2005 gain was a write-off of a note that we deemed unlikely to collect. All of the remaining balance on the note, a total of $160,000, was written off in 2005. In late 2006, we unexpectedly began receiving payments on the note, totaling $85,000, which were recorded as a gain from investments.
Loss on Impairment of Investment. The losses recorded in 2005 represent write-downs of investments in FIC and in a bond held for investment after determining that market declines in the value of these securities should be considered other than temporary. We record pre-tax charges to earnings should the common stock price of the security on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. In 2005 we recorded a charge of $135,000, lowering our cost basis in FIC to $7.65 at December&n