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Pro-Assurance 10-Q 2011

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2011

or

 

¨ Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from              to             

Commission file number 0-16533

 

 

ProAssurance Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   63-1261433

(State or Other Jurisdiction of

Incorporation or Organization)

  (IRS Employer Identification No.)
100 Brookwood Place, Birmingham, AL   35209
(Address of Principal Executive Offices)   (Zip Code)
(205) 877-4400  

(Registrant’s Telephone Number,

Including Area Code)

 

(Former Name, Former Address, and Former

Fiscal Year, if Changed Since Last Report)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter), during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of October 26, 2011, there were 30,535,667 shares of the registrant’s common stock outstanding.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     33   

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     58   

ITEM 4. CONTROLS AND PROCEDURES

     60   

PART II. OTHER INFORMATION

     61   

ITEM 1. LEGAL PROCEEDINGS

     61   

ITEM 1A. RISK FACTORS

     61   

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     61   

ITEM 6. EXHIBITS

     62   

SIGNATURE

     63   

EX-31.1

  

EX-31.2

  

EX-32.1

  

EX-32.2

  

EX-101 INSTANCE DOCUMENT

  

EX-101 SCHEMA DOCUMENT

  

EX-101 CALCULATION LINKBASE DOCUMENT

  

EX-101 LABELS LINKBASE DOCUMENT

  

EX-101 PRESENTATION LINKBASE DOCUMENT

  

EX-101 DEFINITION LINKBASE DOCUMENT

  


Table of Contents

FORWARD-LOOKING STATEMENTS

Any statements in this Form 10-Q that are not historical facts are specifically identified as forward-looking statements. These statements are based upon our estimates and anticipation of future events and are subject to certain risks and uncertainties that could cause actual results to vary materially from the expected results described in the forward-looking statements. Forward-looking statements are identified by words such as, but not limited to, “anticipate”, “believe”, “estimate”, “expect”, “hope”, “hopeful”, “intend”, “may”, “optimistic”, “preliminary”, “potential”, “project”, “should”, “will” and other analogous expressions. There are numerous factors that could cause our actual results to differ materially from those in the forward-looking statements. Thus, sentences and phrases that we use to convey our view of future events and trends are expressly designated as forward-looking statements as are sections of this Form 10-Q that are identified as giving our outlook on future business.

Forward-looking statements relating to our business include among other things: statements concerning liquidity and capital requirements, investment valuation and performance, return on equity, financial ratios, net income, premiums, losses and loss reserves, premium rates and retention of current business, competition and market conditions, the expansion of product lines, the development or acquisition of business in new geographical areas, the availability of acceptable reinsurance, actions by regulators and rating agencies, court actions, legislative actions, payment or performance of obligations under indebtedness, payment of dividends, and other matters.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following factors that could affect the actual outcome of future events:

 

   

general economic conditions, either nationally or in our market areas, that are different than anticipated;

 

   

regulatory, legislative and judicial actions or decisions that could affect our business plans or operations;

 

   

the enactment or repeal of tort reforms;

 

   

formation or dissolution of state-sponsored medical professional liability insurance entities that could remove or add sizable groups of physicians from the private insurance market;

 

   

the impact of deflation or inflation;

 

   

changes in the interest rate environment;

 

   

changes in U.S. laws or government regulations regarding financial markets or market activity that may affect the U.S. economy and our business;

 

   

changes in the ability of the U.S. government to meet its obligations that may affect the U.S. economy and our business;

 

   

performance of financial markets affecting the fair value of our investments or making it difficult to determine the value of our investments;

 

   

changes in accounting policies and practices that may be adopted by our regulatory agencies and the Financial Accounting Standards Board, the Securities and Exchange Commission, or the Public Company Accounting Oversight Board;

 

   

changes in laws or government regulations affecting medical professional liability insurance or the financial community;

 

   

the effects of changes in the health care delivery system, including but not limited to the Patient Protection and Affordable Care Act;

 

   

uncertainties inherent in the estimate of loss and loss adjustment expense reserves and reinsurance, and changes in the availability, cost, quality, or collectability of insurance/reinsurance;

 

   

the results of litigation, including pre- or post-trial motions, trials and/or appeals we undertake;

 

   

allegation of bad faith which may arise from our handling of any particular claim, including failure to settle;

 

   

loss of independent agents;

 

2


Table of Contents
   

changes in our organization, compensation and benefit plans;

 

   

our ability to retain and recruit senior management;

 

   

our ability to purchase reinsurance and collect recoveries from our reinsurers;

 

   

assessments from guaranty funds;

 

   

our ability to achieve continued growth through expansion into other states or through acquisitions or business combinations;

 

   

changes to the ratings assigned by rating agencies to our insurance subsidiaries, individually or as a group;

 

   

insurance market conditions may alter the effectiveness of our current business strategy and impact our revenues;

 

   

the expected benefits from completed and proposed acquisitions may not be achieved or may be delayed longer than expected due to business disruption, loss of customers, employees and key agents, increased operating costs or inability to achieve cost savings, and assumption of greater than expected liabilities, among other reasons.

Our results may differ materially from those we expect and discuss in any forward-looking statements. The principal risk factors that may cause these differences are described in “Item 1A, Risk Factors” in our Form 10-K and other documents we file with the Securities and Exchange Commission, such as our current reports on Form 8-K, and our regular reports on Form 10-Q.

We caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and advise readers that these factors could affect our financial performance and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. Except as required by law or regulations, we do not undertake and specifically decline any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

3


Table of Contents

ProAssurance Corporation and Subsidiaries

Condensed Consolidated Balance Sheets

Condensed Consolidated Balance Sheets (Unaudited)

(In thousands, except share data)

 

    

September 30

2011

   

December 31

2010

 
  

 

 

 

Assets

    

Investments

    

Fixed maturities available for sale, at fair value

   $ 3,674,572      $ 3,603,754   

Equity securities, available for sale, at fair value

     22        3,637   

Equity securities, trading, at fair value

     73,939        37,286   

Short-term investments

     96,824        168,438   

Business owned life insurance

     52,174        50,484   

Investment in unconsolidated subsidiaries

     114,520        88,754   

Other investments

     34,460        38,078   
  

 

 

 

Total Investments

     4,046,511        3,990,431   

Cash and cash equivalents

     125,707        50,851   

Premiums receivable

     138,011        120,950   

Receivable from reinsurers on paid losses and loss adjustment expenses

     2,760        4,582   

Receivable from reinsurers on unpaid losses and loss adjustment expenses

     283,419        277,436   

Prepaid reinsurance premiums

     14,373        11,023   

Deferred policy acquisition costs

     27,998        27,281   

Deferred taxes

     20,359        56,862   

Real estate, net

     40,767        43,951   

Intangible assets

     54,834        60,031   

Goodwill

     159,625        161,453   

Other assets

     74,445        70,205   
  

 

 

 

Total Assets

   $ 4,988,809      $ 4,875,056   
  

 

 

 

Liabilities and Shareholders’ Equity

    

Liabilities

    

Policy liabilities and accruals

    

Reserve for losses and loss adjustment expenses

   $ 2,393,092      $ 2,414,100   

Unearned premiums

     277,702        256,050   

Reinsurance premiums payable

     110,681        111,680   
  

 

 

 

Total Policy Liabilities

     2,781,475        2,781,830   

Other liabilities

     135,657        186,259   

Long-term debt, $35,503 and $35,488, at amortized cost, respectively; $14,411 and $15,616 at fair value, respectively

     49,914        51,104   
  

 

 

 

Total Liabilities

     2,967,046        3,019,193   

Shareholders’ Equity

    

Common shares, par value $0.01 per share, 100,000,000 shares authorized, 34,534,526 and 34,419,383 shares issued, respectively

     345        344   

Additional paid-in capital

     537,039        532,213   

Accumulated other comprehensive income (loss), net of deferred tax expense (benefit) of $65,882 and $42,607, respectively

     122,348        79,124   

Retained earnings

     1,566,888        1,428,026   
  

 

 

 
     2,226,620        2,039,707   

Treasury shares, at cost, 4,007,054 shares and 3,666,149 shares, respectively

     (204,857     (183,844
  

 

 

 

Total Shareholders’ Equity

     2,021,763        1,855,863   
  

 

 

 

Total Liabilities and Shareholders’ Equity

   $ 4,988,809      $ 4,875,056   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Changes in Capital

Condensed Consolidated Statements of Changes in Capital (Unaudited)

(In thousands)

 

     Total    

Accumulated

Other

Comprehensive

Income (Loss)

    

Retained

Earnings

   

Other

Capital

Accounts

 
  

 

 

 

Balance at December 31, 2010

   $ 1,855,863      $ 79,124       $ 1,428,026      $ 348,713   

Net income

     146,494        —           146,494        —     

Dividends to shareholders

     (7,632     —           (7,632     —     

Change in net unrealized gains (losses) on investments, after tax, net of reclassification adjustments

     43,224        43,224         —          —     

Common shares reacquired

     (21,013     —           —          (21,013

Common shares issued for compensation and net effect of performance shares issued and stock options exercised

     (595     —           —          (595

Share-based compensation

     5,422        —           —          5,422   
  

 

 

 

Balance at September 30, 2011

   $ 2,021,763      $ 122,348       $ 1,566,888      $ 332,527   
  

 

 

 
     Total    

Accumulated

Other

Comprehensive

Income (Loss)

    

Retained

Earnings

   

Other

Capital

Accounts

 
  

 

 

 

Balance at December 31, 2009

   $ 1,704,595      $ 59,254       $ 1,196,428      $ 448,913   

Net income

     129,545        —           129,545        —     

Change in net unrealized gains (losses) on investments, after tax, net of reclassification adjustments

     73,263        73,263         —          —     

Common shares reacquired

     (94,426     —           —          (94,426

Common shares issued for compensation and net effect of performance shares issued and stock options exercised

     721        —           —          721   

Share-based compensation

     4,509        —           —          4,509   
  

 

 

 

Balance at September 30, 2010

   $ 1,818,207      $ 132,517       $ 1,325,973      $ 359,717   
  

 

 

 

 

5


Table of Contents

ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Income

Condensed Consolidated Statements of Income (Unaudited)

(In thousands, except per share data)

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
  

 

 

 
     2011     2010     2011     2010  
  

 

 

 

Revenues

        

Gross premiums written

   $ 174,680      $ 158,998      $ 450,795      $ 414,697   
  

 

 

 

Net premiums written

   $ 164,798      $ 149,693      $ 421,692      $ 383,783   
  

 

 

 

Premiums earned

   $ 145,844      $ 140,802      $ 429,627      $ 411,006   

Premiums ceded

     (11,217     (10,502     (25,861     (31,882
  

 

 

 

Net premiums earned

     134,627        130,300        403,766        379,124   

Net investment income

     34,116        35,639        106,573        110,348   

Equity in earnings (loss) of unconsolidated subsidiaries

     (2,264     (1,281     (6,044     2,544   

Net realized investment gains (losses):

        

Other-than-temporary impairment losses (OTTI)

     (1,389     (698     (4,291     (13,077

Portion of OTTI losses recognized in (reclassified from) other comprehensive income before taxes

     (142     113        (823     119   
  

 

 

 

Net impairment losses recognized in earnings

     (1,531     (585     (5,114     (12,958

Other net realized investment gains (losses)

     (10,441     15,297        (534     21,765   
  

 

 

 

Total net realized investment gains (losses)

     (11,972     14,712        (5,648     8,807   

Other income

     7,471        1,764        11,745        5,769   
  

 

 

 

Total revenues

     161,978        181,134        510,392        506,592   

Expenses

        

Losses and loss adjustment expenses

     71,777        86,866        218,270        251,944   

Reinsurance recoveries

     (8,601     (7,055     (20,319     (24,908
  

 

 

 

Net losses and loss adjustment expenses

     63,176        79,811        197,951        227,036   

Underwriting, policy acquisition and operating expenses

     34,954        32,095        103,534        94,940   

Interest expense

     932        832        2,645        2,472   
  

 

 

 

Total expenses

     99,062        112,738        304,130        324,448   
  

 

 

 

Income before income taxes

     62,916        68,396        206,262        182,144   

Provision for income taxes

        

Current expense (benefit)

     19,220        24,155        46,049        56,080   

Deferred expense (benefit)

     (9     (6,811     13,719        (3,481
  

 

 

 

Total income tax expense (benefit)

     19,211        17,344        59,768        52,599   
  

 

 

 

Net income

   $ 43,705      $ 51,052      $ 146,494      $ 129,545   
  

 

 

 

Earnings per share:

        

Basic

   $ 1.43      $ 1.61      $ 4.79      $ 4.03   
  

 

 

 

Diluted

   $ 1.42      $ 1.59      $ 4.75      $ 3.99   
  

 

 

 

Weighted average number of common shares outstanding:

        

Basic

     30,557        31,642        30,577        32,135   
  

 

 

 

Diluted

     30,847        32,047        30,844        32,508   
  

 

 

 

Cash dividends declared per common share

   $ 0.25        —        $ 0.25        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

Condensed Consolidated Statements of Comprehensive Income (Unaudited)

(In thousands)

 

     Three Months Ended
September 30
     Nine Months Ended
September 30
 
  

 

 

 
     2011      2010      2011      2010  
  

 

 

 

Comprehensive income:

           

Net income

   $ 43,705       $ 51,052       $ 146,494       $ 129,545   

Change in net unrealized gains (losses) on investments, after tax, net of reclassification adjustments

     23,291         27,878         43,224         73,263   
  

 

 

 

Comprehensive income

   $ 66,996       $ 78,930       $ 189,718       $ 202,808   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows

Condensed Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

 

     Nine Months Ended
September 30
 
  

 

 

 
     2011     2010  
  

 

 

 

Operating Activities

    

Net income

   $ 146,494      $ 129,545   

Depreciation and amortization

     27,182        19,571   

Net realized investment (gains) losses

     5,648        (8,807

Share-based compensation

     5,422        4,509   

Deferred income taxes

     13,719        (3,481

Other

     (328     7,232   

Other changes in assets and liabilities:

    

Premiums receivable

     (17,061     (1,212

Other assets

     4,090        (9,423

Reserve for losses and loss adjustment expenses

     (21,008     (16,402

Unearned premiums

     21,652        5,238   

Reinsurance related assets and liabilities

     (8,510     7,158   

Other liabilities

     (70,882     (25,302
  

 

 

 

Net cash provided by operating activities

     106,418        108,626   

Investing Activities

    

Purchases of:

    

Fixed maturities available for sale

     (597,762     (663,341

Equity securities trading

     (87,787     (13,450

Other investments

     (429     (5,383

(Investments in) distributions from unconsolidated subsidiaries, net:

    

Tax credit limited partnerships

     (21,542     (8,783

Other partnership investments

     —          24,601   

Proceeds from sale or maturities of:

    

Fixed maturities available for sale

     586,455        777,596   

Equity securities available for sale

     3,836        271   

Equity securities trading

     40,648        26,887   

Other investments

     596        1,242   

Net sales or maturities (purchases) of short-term investments

     71,614        (150,942

Unsettled security transactions, net

     4,897        9,344   

Cash received (paid) for other assets

     (9,581     (2,752
  

 

 

 

Net cash provided (used) by investing activities

     (9,055     (4,710

Financing Activities

    

Repurchase of treasury shares

     (21,013     (94,426

Other

     (1,494     (1,868
  

 

 

 

Net cash provided (used) by financing activities

     (22,507     (96,294
  

 

 

 

Increase (decrease) in cash and cash equivalents

     74,856        7,622   

Cash and cash equivalents at beginning of period

     50,851        40,642   
  

 

 

 

Cash and cash equivalents at end of period

   $ 125,707      $ 48,264   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

1. Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of ProAssurance Corporation and its consolidated subsidiaries (ProAssurance or PRA). The financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation, consisting of normal recurring adjustments, have been included. ProAssurance’s results for the three-month and nine-month periods ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. The accompanying Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes contained in ProAssurance’s December 31, 2010 report on Form 10-K. In connection with its preparation of the Condensed Consolidated Financial Statements, ProAssurance evaluated events that occurred subsequent to September 30, 2011 for recognition or disclosure in its financial statements and notes to financial statements.

Reclassifications

As of September 30, 2011, ProAssurance has reported intangible assets as a separate line item on the Balance Sheet. Prior period balances in this report have been reclassified to conform to the 2011 presentation. The reclassification had no effect on income from continuing operations, net income or total assets.

Accounting Changes Not Yet Adopted

Intangibles, Goodwill and Other

Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to goodwill impairment testing. The new guidance permits the assessment of qualitative factors to determine whether events or circumstances lead to the conclusion that it is necessary to perform the two-step goodwill impairment test. Entities are not required to calculate the fair value of a reporting unit unless they conclude that it is more likely than not that the unit’s carrying value is greater than its fair value based on an assessment of events and circumstances. ProAssurance plans to adopt the guidance during the fourth quarter of 2011. Adoption of this guidance is not expected to have a material effect on ProAssurance’s results of operations or financial position.

Presentation of Comprehensive Income

Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to the presentation of comprehensive income. The new guidance establishes two acceptable options for the presentation of comprehensive income: 1) separate consecutive statements of net income and comprehensive income or 2) a single continuous statement of comprehensive income that includes both the computation of net income and the computation of other comprehensive income. Regardless of the option chosen, reclassification adjustments between other comprehensive income and net income must be presented on the face of the financial statements; total comprehensive income must also be presented. The guidance is applicable to all periods presented. ProAssurance plans to adopt the guidance on January 1, 2012. Adoption of this guidance will have no effect on ProAssurance’s results of operations or financial position.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Fair Value Measurements

Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to fair value measurements and disclosures, all of which are to be applied prospectively. The new guidance increases disclosure requirements regarding valuation methods used to determine fair value measurements categorized as Level 3, as well as the sensitivity to change of those measurements, and requires additional disclosures regarding the consideration given to highest and best use in fair value measurements of nonfinancial assets. The guidance also requires that when fair value measurements of items not carried at fair value are disclosed, the fair value measurements are to be categorized by level of the fair value hierarchy. Additionally, the guidance also clarifies or revises certain fair value measurement principles related to the valuation of financial instruments managed within a portfolio, the valuation of instruments classified as a part of shareholders’ equity, the appropriate application of the highest and best use valuation premise, and the consideration of premium and discounts in a fair value measurement. ProAssurance plans to adopt the guidance beginning January 1, 2012. Adoption of this guidance is not expected to have a material effect on ProAssurance’s results of operations or financial position.

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

Effective for fiscal years beginning after December 15, 2011, the FASB revised guidance regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The guidance permits deferral of qualifying costs associated only with successful contract acquisitions. Internal selling agent and underwriter salary and benefit costs allocated to unsuccessful contracts, as well as advertising costs, are excluded. The guidance must be applied prospectively, but may be applied retrospectively for all prior periods. ProAssurance plans to adopt the guidance beginning January 1, 2012. Adoption of this guidance is not expected to have a material effect on ProAssurance’s results of operations or financial position.

Accounting Changes

Intangibles, Goodwill and Other

Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance related to goodwill impairment testing. The revised guidance clarifies that when evaluating goodwill associated with a reporting unit that has a zero or negative carrying value, an initial determination should be made as to whether it is more likely than not that the goodwill is impaired. When impairment is more likely than not, the goodwill is required to be tested for impairment. ProAssurance adopted the guidance on January 1, 2011. Adoption had no material effect on ProAssurance’s results of operations or financial position.

Fair Value Measurements

Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance to require additional disclosure about purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements. ProAssurance adopted the guidance on January 1, 2011. Adoption had no effect on ProAssurance’s results of operations or financial position.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

2. Acquisitions

All entities acquired have been accounted for in accordance with GAAP relating to business combinations and are considered to be a part of ProAssurance’s sole reporting segment, the professional liability segment.

On November 30, 2010 ProAssurance acquired 100% of the outstanding shares of American Physicians Service Group, Inc. (APS) as a means of expanding its professional liability business. Total purchase consideration transferred had a fair value of $237 million on the acquisition date and included cash of $233 million and deferred compensation commitments of $4 million.

In the third quarter of 2011, Goodwill related to the purchase of APS was reduced by $1.8 million related to the completion of the valuation of pre-acquisition tax liabilities.

ProAssurance 2011 operating results include revenue and earnings attributable to the operations acquired from APS as follows:

 

(In thousands)    Three Months Ended
September 30, 2011
     Nine Months Ended
September 30, 2011
 
  

 

 

 

Revenue

   $ 15,309       $ 46,899   

Earnings

   $ 3,035       $ 12,815   

The following table provides ProAssurance Pro Forma Consolidated Results as if ProAssurance had acquired APS on January 1, 2010. Pro Forma results reflect ProAssurance Consolidated results, adjusted, net of related tax effects, as follows: 1) in 2010, to include the operating results of APS, 2) to reflect APS related workforce reductions as if the transaction had occurred on January 1, 2010, 3) to exclude the direct costs of completing the APS transaction, 4) to include amortization of APS policy acquisition costs written off upon acquisition, and 5) to reflect amortization of certain purchase adjustments (valuation of investment assets at fair value; intangibles recorded as a part of the purchase price allocation) beginning January 1, 2010. ProAssurance Actual Consolidated Results are also presented for comparative purposes. The ProAssurance Actual Consolidated results for the three and nine months ended September 30, 2010 do not include the operating results of APS because the APS acquisition did not occur until November 30, 2010.

     Three Months Ended
September 30, 2011
     Nine Months Ended
September 30, 2011
 
  

 

 

    

 

 

 
(In thousands)    ProAssurance
Pro Forma
Consolidated
Results
     ProAssurance
Actual
Consolidated
Results
     ProAssurance
Pro Forma
Consolidated
Results
     ProAssurance
Actual
Consolidated
Results
 
  

 

 

    

 

 

 

Revenue

   $ 161,978       $ 161,978       $ 510,392       $ 510,392   

Earnings

   $ 44,555       $ 43,705       $ 147,923       $ 146,494   
     Three Months Ended
September 30, 2010
     Nine Months Ended
September 30, 2010
 
  

 

 

    

 

 

 
(In thousands)    ProAssurance
Pro Forma
Consolidated
Results
     ProAssurance
Actual
Consolidated
Results
     ProAssurance
Pro Forma
Consolidated
Results
     ProAssurance
Actual
Consolidated
Results
 
  

 

 

    

 

 

 

Revenue

   $ 199,306       $ 181,134       $ 565,199       $ 506,592   

Earnings

   $ 55,413       $ 51,052       $ 143,786       $ 129,545   

For additional information regarding the acquisition, see Note 2 of the Notes to the Consolidated Financial Statements in ProAssurance’s 2010 Form 10-K.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

3. Fair Value Measurement

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A three level hierarchy has been established for valuing assets and liabilities based on how transparent (observable) the inputs are that are used to determine fair value, with the inputs considered most observable categorized as Level 1 and those that are the least observable categorized as Level 3. Hierarchy levels are defined as follows:

 

Level 1:

  quoted (unadjusted) market prices in active markets for identical assets and liabilities. For ProAssurance, Level 1 inputs are generally quotes for debt or equity securities actively traded in exchange or over-the-counter markets.

Level 2:

  market data obtained from sources independent of the reporting entity (observable inputs). For ProAssurance, Level 2 inputs generally include quoted prices in markets that are not active, quoted prices for similar assets/liabilities, and results from pricing models that use observable inputs such as interest rates and yield curves that are generally available at commonly quoted intervals.

Level 3:

  the reporting entity’s own assumptions about market participant assumptions based on the best information available in the circumstances (non-observable inputs). For ProAssurance, Level 3 inputs are used in situations where little or no Level 1 or 2 inputs are available or are inappropriate given the particular circumstances. Level 3 inputs include results from pricing models for which some or all of the inputs are not observable, discounted cash flow methodologies, single non-binding broker quotes and adjustments to externally quoted prices that are based on management judgment or estimation.

The following tables present information about ProAssurance’s assets and liabilities that are measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010 and indicate the fair value hierarchy of the valuation techniques utilized to determine such value. For some assets, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. When this is the case, the asset is categorized based on the level of the most significant input to the fair value measurement. ProAssurance’s assessment of the significance of a particular input to the fair value measurement requires judgment and considers factors specific to the assets being valued.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Assets and liabilities measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010, including financial instruments for which ProAssurance has elected fair value accounting, are as follows:

     September 30, 2011  
  

 

 

 
     Fair Value Measurements Using     

Total

 
  

 

 

    
(In thousands)    Level 1      Level 2      Level 3      Fair Value  
  

 

 

 

Assets:

           

Fixed maturities, available for sale

           

U.S. Treasury obligations

   $ —         $ 310,547       $ —         $ 310,547   

U.S. Agency obligations

     —           87,079         —           87,079   

State and municipal bonds

     —           1,165,798         7,250         1,173,048   

Corporate debt, multiple observable inputs

     —           1,361,150         —           1,361,150   

Corporate debt, limited observable inputs:

           

Private placement senior notes

     —           —           617         617   

Other corporate debt, NRSRO ratings available

     —           —           8,227         8,227   

Other corporate debt, NRSRO ratings not available

     —           —           1,252         1,252   

Residential mortgage-backed securities

     —           563,568         —           563,568   

Commercial mortgage-backed securities

     —           81,729         —           81,729   

Other asset-backed securities

     —           87,355         —           87,355   

Equity securities, available for sale

           

Financial

     22         —           —           22   

Equity securities, trading

           

Financial

     14,503         —           —           14,503   

Energy

     10,811         —           —           10,811   

Consumer cyclical

     7,114         —           —           7,114   

Consumer non-cyclical

     15,494         —           —           15,494   

Technology

     4,926         —           —           4,926   

Industrial

     7,511         —           —           7,511   

Communications

     4,802         —           —           4,802   

Index funds

     3,549         —           —           3,549   

All other

     5,229         —           —           5,229   

Short-term investments

     84,299         12,525         —           96,824   

Financial instruments carried at fair value, classified as a part of:

           

Investment in unconsolidated subsidiaries

     —           —           24,830         24,830   

Other investments

     —           —           16,191         16,191   
  

 

 

 

Total assets

   $ 158,260       $ 3,669,751       $ 58,367       $ 3,886,378   
  

 

 

 

Liabilities:

           

2019 Note Payable

     —           —           14,411         14,411   

Interest rate swap agreement

     —           —           4,749         4,749   
  

 

 

 

Total liabilities

   $ —         $ —         $ 19,160       $ 19,160   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

     December 31, 2010  
  

 

 

 
     Fair Value Measurements Using     

Total

 
  

 

 

    
(In thousands)    Level 1      Level 2      Level 3      Fair Value  
  

 

 

 

Assets:

           

Fixed maturities, available for sale

           

U.S. Treasury obligations

   $ —         $ 225,908       $ —         $ 225,908   

U.S. Agency obligations

     —           68,878         —           68,878   

State and municipal bonds

     —           1,236,374         7,550         1,243,924   

Corporate debt, multiple observable inputs

     —           1,312,035         —           1,312,035   

Corporate debt, limited observable inputs:

           

Private placement senior notes

     —           —           9,356         9,356   

Other corporate debt, NRSRO ratings available

     —           —           10,414         10,414   

Other corporate debt, NRSRO ratings not available

     —           —           1,459         1,459   

Residential mortgage-backed securities

     —           567,640         2,198         569,838   

Commercial mortgage-backed securities

     —           99,386         —           99,386   

Other asset-backed securities

     —           62,534         22         62,556   

Equity securities, available for sale

           

Financial

     392         —           —           392   

Energy

     257         —           —           257   

Consumer cyclical

     521         —           —           521   

Consumer non-cyclical

     656         —           —           656   

Technology

     768         —           —           768   

Industrial

     737         —           —           737   

All Other

     306         —           —           306   

Equity securities, trading

           

Financial

     4,317         —           —           4,317   

Energy

     7,149         —           —           7,149   

Consumer cyclical

     1,599         —           —           1,599   

Consumer non-cyclical

     4,534         —           —           4,534   

Technology

     3,400         —           —           3,400   

Industrial

     2,403         —           —           2,403   

Communications

     2,623         —           —           2,623   

Index funds

     3,568         —           —           3,568   

All other

     7,693         —           —           7,693   

Short-term investments

     150,344         18,094         —           168,438   

Financial instruments carried at fair value, classified as a part of Investment in unconsolidated subsidiaries

     —           —           25,112         25,112   
  

 

 

 

Total assets

   $ 191,267       $ 3,590,849       $ 56,111       $ 3,838,227   
  

 

 

 

Liabilities:

           

2019 Note Payable

     —           —           15,616         15,616   

Interest rate swap agreement

     —           —           3,658         3,658   
  

 

 

 

Total liabilities

   $ —         $ —         $ 19,274       $ 19,274   
  

 

 

 

The fair values for securities included in the Level 2 category, with the few exceptions described below, have been developed by third party, nationally recognized pricing services. These services use complex methodologies to determine values for securities and subject the values they develop to quality control reviews. The services collect and utilize multiple inputs, although not all inputs are used for every security type or given the same priority in every evaluation. Inputs used include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, and offers. The services also consider credit ratings, where appropriate, including ratings updates and information available in appropriate market research publications. Management reviews service-provided values for reasonableness by comparing market yields indicated by the supplied value to yields observed in the market place. If a value does not appear reasonable, the valuation is discussed with the service that provided the value and would be adjusted, if necessary. No such adjustments have been necessary in 2011 or 2010.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Below is a summary description of the valuation methodologies primarily used by the pricing services for securities in the Level 2 category, by security type:

U.S. Treasury obligations are valued based on quoted prices for identical assets, or, in markets that are not active, quotes for similar assets, taking into consideration adjustments for variations in contractual cash flows and yields to maturity.

U.S. Agency obligations are valued using pricing models that consider current and historical market data, normal trading conventions, credit ratings, and the particular structure and characteristics of the security being valued, such as yield to maturity, redemption options, and contractual cash flows. Adjustments to model inputs or model results are included in the valuation process when necessary to reflect recent events, such as regulatory, government or corporate actions or significant economic, industry or geographic events that would affect the security’s fair value.

State and municipal bonds are valued using a series of matrices that consider credit ratings, the structure of the security, the sector in which the security falls, yields, and contractual cash flows. Valuations are further adjusted, when necessary, to reflect recent events such as significant economic or geographic events or ratings changes that would affect the security’s fair value.

Corporate debt with multiple observable inputs, consists primarily of corporate bonds, but also includes a small number of bank loans. The methodology used to value Level 2 corporate bonds is the same as the methodology previously described for U.S. agency obligations. Bank loans are valued by an outside vendor based upon a widely distributed, loan-specific listing of average bid and ask prices published daily by an investment industry group. The publisher of the listing derives the averages from data received from multiple market-makers for bank loans.

Residential and commercial mortgage backed securities. Agency pass through securities are valued by a matrix, considering the issuer type, coupon rate and longest cash flows outstanding. The matrix is developed daily based on available market information. Agency and non-agency collateralized mortgage obligations are both valued using models that consider the structure of the security, current and historical information regarding prepayment speeds, ratings and ratings updates, and current and historical interest rate and interest rate spread data. Evaluations of Alt-A and subprime mortgages include a review of collateral performance data, which is generally updated monthly.

Other asset-backed securities are valued using models that consider the structure of the security, monthly payment information, current and historical information regarding prepayment speeds, ratings and ratings updates, and current and historical interest rate and interest rate spread data. Spreads and prepayment speeds consider collateral type.

Short term investments, included in the Level 2 category, are commercial paper and certificates of deposit maturing within one year, carried at cost which approximates the fair value of the security due to the short term to maturity.

Below is a summary description of the valuation methodologies used to value securities in the Level 3 category by security type.

State and municipal bonds consists of auction rate municipal bonds valued internally using a model based on discounted cash flows using yields currently available on fixed rate securities with a similar term and collateral, adjusted to consider the effect of a floating rate and a premium for illiquidity. All are rated A or better.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Corporate debt with limited observable inputs, exclusive of private placement senior notes, consist of corporate bonds valued internally using dealer quotes for similar securities or discounted cash flow models using yields currently available for similar securities. Similar securities are defined as securities having like terms and payment features that are of comparable credit quality. Assessments of credit quality are based on NRSRO ratings, if available, or are subjectively determined by management if not available. At September 30, 2011, the average NRSRO rating of rated securities is BBB+. Private placement senior notes are valued by an outside vendor rather than a third-party pricing service. The valuation is prepared based on a widely available matrix that is produced daily by a leading seller of secondary private placements. The matrix considers the market sector, issuer credit ratings and the remaining loan term and is developed from market data such as interest rate yield curves, credit spreads, quoted market prices for comparable securities and other applicable market data. At both September 30, 2011 and December 31, 2010 Level 3 corporate debt includes private placement senior notes which are unconditionally guaranteed by large regional banks; other corporate debt securities in the Level 3 category are not guaranteed or fully collateralized.

Other asset-backed securities are valued using multiple inputs including multiple broker dealer quotes.

Investments in unconsolidated subsidiaries and Other investments, included in the Level 3 category, are comprised of limited partnership (LP) and limited liability company (LLC) interests that are valued using net asset values provided by the LP/LLC, which approximates the fair value of the interest. The following table provides additional information regarding these interests:

     Fair Value      Unfunded
Commitments
  

 

 

(In thousands)   

September 30,

2011

     December 31,
2010
    

September 30,

2011

  

 

 

Investment in unconsolidated subsidiaries:

        

LP primarily invested in long/short equities (1)

   $ 17,836       $ 18,801       None

LP primarily invested in non-public equities (2)

     6,994         6,311       None
  

 

 

    
     24,830       $ 25,112      
     

 

 

    

Other investments:

        

LLC primarily invested in non-public investment companies (3)

     16,191          None
  

 

 

       
   $ 41,021         
  

 

 

       

 

(1) The LP holds both long and short U.S. and North American equities, and targets absolute returns using a strategy designed to take advantage of event-driven market opportunities. Redemptions are allowed with a notice requirement of up to 45 days and are paid within 30 days of the redemption date, unless the redemption request is for 90% or more of the requestor’s capital balance. Redemptions at the 90% and above level will be paid at 90%, with the remainder paid after the LP’s annual audit.
(2) The LP is structured to provide capital appreciation through diversified investments in private equity, including investments in buyout, venture capital, mezzanine debt, distressed debt and other private equity-oriented LPs. Redemptions are not allowed, except by special permission of the LP. Income and capital are to be periodically distributed at the discretion of the LP over an anticipated time frame that spans 3 to 5 years.
(3) The LLC is structured to provide income through diversified investments in private equity, including mezzanine debt, distressed debt, syndicated bank loans and other private equity-oriented investments. Income and capital are required to be distributed back to equity holders at the discretion of the fund manager over a ten year period ending July, 2016. Redemptions are not permitted. The LLC has obtained approval from equity holders to convert into a publicly traded investment fund; but the conversion has not yet occurred.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

The following tables (the Level 3 Tables) present summary information regarding changes in the fair value of assets and liabilities measured at fair value using Level 3 inputs, including financial instruments for which ProAssurance has elected fair value accounting.

     September 30, 2011  
     Level 3 Fair Value Measurements – Assets  
(In thousands)   

State and

Municipal

Bonds

    Corporate
Debt
   

Asset-
backed

Securities

    Investment in
Unconsolidated
Subsidiaries
    Other
Investments
     Total  
  

 

 

 

Balance June 30, 2011

   $ 7,325      $ 7,830      $ 1,684      $ 25,127      $ —         $ 41,966   

Total gains (losses) realized and unrealized, included in earnings, as a part of:

             

Equity in earnings of unconsolidated subsidiaries

     —          —          —          (297     —           (297

Net realized investment gains (losses)

     —          —          —          —          —           —     

Included in other comprehensive income

     —          (638     —          —          —           (638

Purchases

     —          —          —          —          —           —     

Sales

     (75     —          —          —          —           (75

Transfers in

     —          2,904        —          —          16,191         19,095   

Transfers out

     —          —          (1,684     —          —           (1,684
  

 

 

 

Balance September 30, 2011

   $ 7,250      $ 10,096      $ —        $ 24,830      $ 16,191       $ 58,367   
  

 

 

 

Change in unrealized gains (losses) included in earnings for the above period for Level 3 assets held at period-end

   $ —        $ —        $ —        $ (297   $ —         $ (297
  

 

 

 

 

     September 30, 2011  
     Level 3 Fair Value Measurements – Assets  
(In thousands)   

State and

Municipal

Bonds

    Corporate
Debt
   

Asset-
backed

Securities

    Investment in
Unconsolidated
Subsidiaries
    Other
Investments
     Total  
  

 

 

 

Balance December 31, 2010

   $ 7,550      $ 21,229      $ 2,220      $ 25,112      $ —         $ 56,111   

Total gains (losses) realized and unrealized, included in earnings, as a part of:

             

Equity in earnings of unconsolidated subsidiaries

     —          —          —          (282     —           (282

Net realized investment gains (losses)

     —          —          314        —          —           314   

Included in other comprehensive income

     —          (1,352     (15     —          —           (1,367

Purchases

     —          —          1,684        —          —           1,684   

Sales

     (300     (8,504     (1,921     —          —           (10,725

Transfers in

     —          6,350        —          —          16,191         22,541   

Transfers out

     —          (7,627     (2,282     —          —           (9,909
  

 

 

 

Balance September 30, 2011

   $ 7,250      $ 10,096      $ —        $ 24,830      $ 16,191       $ 58,367   
  

 

 

 

Change in unrealized gains (losses) included in earnings for the above period for Level 3 assets held at period-end

   $ —        $ —        $ —        $ (282   $ —         $ (282
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

     September 30, 2010  
     Level 3 Fair Value Measurements - Assets  
(In thousands)   

State and

Municipal

Bonds

    Corporate
Debt
   

Asset-
backed

Securities

     Investment in
Unconsolidated
Subsidiaries
    Other
Investments
    Total  
  

 

 

 

Balance June 30, 2010

   $ 9,401      $ 25,660      $ —         $ 57,488      $ 930      $ 93,479   

Total gains (losses) realized and unrealized, included in earnings, as a part of:

             

Equity in earnings of unconsolidated subsidiaries

     —          —          —           633        —          633   

Net realized investment gains (losses)

     —          59        —           —          —          59   

Included in other comprehensive income

     (1,131     (130     —           —          74        (1,187

Purchases

     —          3,959        —           —          —          3,959   

Sales

     (50     (4,755     —           (33,042     —          (37,847

Transfers in

     —          —          1,004         —          —          1,004   

Transfers out

     —          (491     —           —          (1,004     (1,495
  

 

 

 

Balance September 30, 2010

   $ 8,220      $ 24,302      $ 1,004       $ 25,079      $ —        $ 58,605   
  

 

 

 

Change in unrealized gains (losses) included in earnings for the above period for Level 3 assets held at period-end

   $ —        $ 59      $ —         $ 633      $ —        $ 692   
  

 

 

 

 

    September 30, 2010  
    Level 3 Fair Value Measurements – Assets  
(In thousands)  

State and

Municipal

Bonds

    Corporate
Debt
   

Asset-
backed

Securities

    Investment in
Unconsolidated
Subsidiaries
    Other
Investments
    Total  
 

 

 

 

Balance December 31, 2009

  $ 9,495      $ 24,335      $ 940      $ 48,502      $ 10,932      $ 94,204   

Total gains (losses) realized and unrealized, included in earnings, as a part of:

           

Equity in earnings of unconsolidated subsidiaries

    —          —          —          4,618        —          4,618   

Net realized investment gains (losses)

    —          59        —          —          (10,698     (10,639

Included in other comprehensive income

    (1,049     (106     60        —          11,953        10,858   

Purchases

    —          5,510        —          5,000        731        11,241   

Sales

    (226     (4,995     —          (33,041     (1,242     (39,504

Transfers in

    —          151        1,004        —          —          1,155   

Transfers out

    —          (652     (1,000     —          (11,676     (13,328
 

 

 

 

Balance September 30, 2010

  $ 8,220      $ 24,302      $ 1,004      $ 25,079      $ —        $ 58,605   
 

 

 

 

Change in unrealized gains (losses) included in earnings for the above period for Level 3 assets held at period-end

  $ —        $ 59      $ —        $ 4,618      $ (10,698   $ (6,021
 

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Transfers

There were no transfers between Level 1 and Level 2 for the three and nine months ended September 30, 2011, or for the three and nine months ended September 30, 2010.

Transfers shown in the preceding Level 3 Tables are as of the end of period and were to or from Level 2, unless otherwise noted.

Transfers summarized in the Level 3 Tables include:

 

   

For the three- and nine-month periods ended September 30, 2011, an interest in an LLC (classified as a part of Other Investments) began to be included in the Level 3 Tables. The interest is accounted for using the cost method, but due to the recognition of OTTIs, is carried at fair value, $16.2 million at September 30, 2011. The fund is expected to convert to a public fund in the near term. After conversion, the investment is expected to be classified as an available-for-sale security, valued at fair value.

 

   

For the three-month period ended September 30, 2010, asset-backed securities valued at $1 million that were previously held in a private investment fund became directly held and were reclassified from Other Investments to Asset-backed Securities.

 

   

For the nine-month period ended September 30, 2010, beneficially owned asset-backed securities held in a private investment fund (classified as a part of Other Investments) having a fair value of $10.7 million were transferred from Level 3 to Level 2 because the fund manager provided additional information regarding the valuation methodologies followed. Previously, the investments were 100% categorized as Level 3 because valuations were determined by the fund manager using various methodologies, not all of which were based on multiple observable inputs.

 

   

All remaining transfers relate to securities held for which there is little market activity for identical or nearly identical securities in a given quarter. Such securities are valued using multiple observable inputs when those inputs are available; otherwise the securities are valued using limited observable inputs.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

     September 30, 2011  
             Level 3 Fair Value  Measurements - Liabilities          
(In thousands)   

2019

Note

Payable

    Interest
rate swap
agreement
     Total  
  

 

 

 

Balance June 30, 2011

   $ 15,863      $ 3,852       $ 19,715   

Total (gains) losses realized and unrealized:

       

Included in earnings as a part of net realized investment (gains) losses

     (1,370     897         (473

Settlements

     (82     —           (82
  

 

 

 

Balance September 30, 2011

   $ 14,411      $ 4,749       $ 19,160   
  

 

 

 

Change in unrealized (gains) losses included in earnings for the above period for Level 3 liabilities outstanding at period-end

   $ (1,370   $ 897       $ (473
  

 

 

 
     September 30, 2011  
     Level 3 Fair Value Measurements - Liabilities  
(In thousands)   

2019

Note

Payable

    Interest
rate swap
agreement
     Total  
  

 

 

 

Balance December 31, 2010

   $ 15,616      $ 3,658       $ 19,274   

Total (gains) losses realized and unrealized:

       

Included in earnings as a part of net realized investment (gains) losses

     (962     1,091         129   

Settlements

     (243     —           (243
  

 

 

 

Balance September 30, 2011

   $ 14,411      $ 4,749       $ 19,160   
  

 

 

 

Change in unrealized (gains) losses included in earnings for the above period for Level 3 liabilities outstanding at period-end

   $ (962   $ 1,091       $ 129   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

     September 30, 2010  
     Level 3 Fair Value Measurements - Liabilities  
(In thousands)   

2019

Note

Payable

   

Interest rate
swap

agreement

     Total  
  

 

 

 

Balance June 30, 2010

   $ 15,107      $ 4,284       $ 19,391   

Total (gains) losses realized and unrealized:

       

Included in earnings as a part of net realized investment (gains) losses

     710        548         1,258   

Settlements

     (76     —           (76
  

 

 

 

Balance September 30, 2010

   $ 15,741      $ 4,832       $ 20,573   
  

 

 

 

Change in unrealized (gains) losses included in earnings for the above period for Level 3 liabilities outstanding at period-end

   $ 710      $ 548       $ 1,258   
  

 

 

 

 

     September 30, 2010  
     Level 3 Fair Value Measurements - Liabilities  
(In thousands)   

2019

Note

Payable

    Interest rate
swap
agreement
     Total  
  

 

 

 

Balance December 31, 2009

   $ 14,740      $ 2,937       $ 17,677   

Total (gains) losses realized and unrealized:

       

Included in earnings as a part of net realized investment (gains) losses

     1,229        1,895         3,124   

Settlements

     (228     —           (228
  

 

 

 

Balance September 30, 2010

   $ 15,741      $ 4,832       $ 20,573   
  

 

 

 

Change in unrealized (gains) losses included in earnings for the above period for Level 3 liabilities outstanding at period-end

   $ 1,229      $ 1,895       $ 3,124   
  

 

 

 

Fair Value Option Elections

The 2019 Note Payable and a related interest rate swap agreement (the Swap) are measured at fair value on a recurring basis, with changes in the fair value of each liability recorded in net realized gains (losses). ProAssurance assumed both liabilities as part of a previous acquisition. The fair value option was elected for the 2019 Note Payable and the Swap because valuation at fair value better reflects the economics of the related liabilities and eliminates the inconsistency that would otherwise result from carrying the 2019 Note Payable on an amortized cost basis and the Swap at fair value.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Financial Instruments Not Measured At Fair Value

Financial assets and liabilities which are not measured at fair value on a recurring basis are as follows:

     September 30, 2011      December 31, 2010  
  

 

 

    

 

 

 
(In thousands)   

Carrying

Value

    

Estimated

Fair

Value

     Carrying
Value
    

Estimated

Fair

Value

 
  

 

 

    

 

 

 

Financial assets:

           

Other investments

   $ 18,269       $ 23,793       $ 38,078       $ 44,387   

Investment in unconsolidated subsidiaries

     89,690         99,947         63,642         66,862   

BOLI

     52,174         52,174         50,484         50,484   

Other assets

     8,992         8,992         7,743         7,743   

Financial liabilities:

           

Trust Preferred Securities

   $ 22,992       $ 22,992       $ 22,992       $ 22,992   

Surplus Notes due May 2034

     12,000         12,000         12,000         12,000   

Note Payable due February 2012

     511         518         496         521   

Other liabilities

     18,486         18,459         22,367         21,837   

Other Investments listed in the table above include interests in certain investment fund LP/LLCs accounted for using the cost method, investments in Federal Home Loan Bank (FHLB) common stock carried at cost, and an annuity investment carried at amortized cost. The estimated fair value of the LP/LLC interests is based on NAVs provided by the LP/LLC managers. The fair value of the FHLB common stock is estimated as the carrying value of the investment as it is the amount we would receive if we cancel our membership; the investment has been determined not to have suffered an OTTI and the membership cannot be sold. The fair value of the annuity is the present value of the expected future cash flows discounted using a rate available in active markets for similarly structured instruments.

Investment in Unconsolidated Subsidiaries consists primarily of investments in tax credit partnerships, and an interest in a non-controlling limited liability company. Fair values of investments in tax credit partnerships are based on the present value of the cash flows expected to be generated by the partnerships discounted at rates for investments with similar risk structures and repayment periods. The fair value of the interest in the LLC is estimated at our initial capital contribution which occurred less than one year ago and represented an arm’s length transaction between market participants.

The fair value of the BOLI is the cash surrender value associated with the policies on the valuation date.

Other Assets and Other Liabilities primarily consist of related investment assets and liabilities associated with funded deferred compensation agreements. Included in Other Liabilities are also certain contractual liabilities associated with business combinations completed in 2009 and 2010. Fair values of the funded deferred compensation assets/liabilities are based on the net asset value of the underlying securities. The fair values of the business combination liabilities are based on the present value of the expected cash flows, discounted at ProAssurance’s assumed incremental borrowing rate on the valuation date for unsecured liabilities with similar repayment structures.

The fair value of the long-term debt is the present value of expected underlying cash flows of the debt, discounted at rates available on the valuation date for similar debt issued by entities with a similar credit standing to ProAssurance or, if issued by an insurance subsidiary, the subsidiary issuing the debt.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

4. Investments

The amortized cost and estimated fair value of available-for-sale fixed maturities and equity securities are as follows:

     September 30, 2011  
  

 

 

 
(In thousands)   

Amortized

Cost

    

Gross

Unrealized

Gains

    

Gross

Unrealized

Losses

   

Estimated

Fair

Value

 
  

 

 

 

Fixed maturities

          

U.S. Treasury obligations

   $ 293,301       $ 17,255       $ (9   $ 310,547   

U.S. Agency obligations

     81,337         5,758         (16     87,079   

State and municipal bonds

     1,100,718         72,500         (170     1,173,048   

Corporate debt

     1,313,579         66,405         (8,738     1,371,246   

Residential mortgage-backed securities

     533,195         32,418         (2,045 )*      563,568   

Commercial mortgage-backed securities

     77,958         3,849         (78     81,729   

Other asset-backed securities

     86,267         1,113         (25     87,355   
  

 

 

 
     3,486,355         199,298         (11,081     3,674,572   

Equity securities

     6         16         —          22   
  

 

 

 
   $ 3,486,361       $ 199,314       $ (11,081   $ 3,674,594   
  

 

 

 

 

     December 31, 2010  
  

 

 

 
(In thousands)   

Amortized

Cost

    

Gross

Unrealized

Gains

    

Gross

Unrealized

Losses

   

Estimated

Fair

Value

 
  

 

 

 

Fixed maturities

          

U.S. Treasury obligations

   $ 219,631       $ 7,519       $ (1,242   $ 225,908   

U.S. Agency obligations

     64,804         4,113         (39     68,878   

State and municipal bonds

     1,204,327         44,047         (4,450     1,243,924   

Corporate debt

     1,287,842         52,757         (7,335     1,333,264   

Residential mortgage-backed securities

     549,543         25,409         (5,114 )*      569,838   

Commercial mortgage-backed securities

     95,758         3,663         (35     99,386   

Other asset-backed securities

     61,314         1,373         (131     62,556   
  

 

 

 
     3,483,219         138,881         (18,346     3,603,754   

Equity securities

     2,438         1,212         (13     3,637   
  

 

 

 
   $ 3,485,657       $ 140,093       $ (18,359   $ 3,607,391   
  

 

 

 

 

* Includes other-than-temporary impairments recognized in accumulated other comprehensive income of $3.3 million at September 30, 2011 and $4.1 million at December 31, 2010.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

The recorded cost basis and estimated fair value of available-for-sale fixed maturities at September 30, 2011, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. ProAssurance uses the call date as the contractual maturity for pre-refunded state and municipal bonds which are 100% backed by U.S. Treasury obligations.

(In thousands)    Amortized
Cost
     Due in one
year or less
     Due after
one year
through
five years
     Due after
five years
through
ten years
     Due after
ten years
     Total Fair
Value
 
  

 

 

 

Fixed maturities, available for sale

                 

U.S. Treasury obligations

   $ 293,301       $ 25,105       $ 182,916       $ 98,257       $ 4,269       $ 310,547   

U.S. Agency obligations

     81,337         2,036         59,311         25,455         277         87,079   

State and municipal bonds

     1,100,718         34,708         349,435         549,262         239,643         1,173,048   

Corporate debt

     1,313,579         136,940         695,009         513,274         26,023         1,371,246   

Residential mortgage-backed securities

     533,195                     563,568   

Commercial mortgage-backed securities

     77,958                     81,729   

Other asset-backed securities

     86,267                     87,355   
  

 

 

                

 

 

 
   $ 3,486,355                   $ 3,674,572   
  

 

 

                

 

 

 

Excluding investments in bonds and notes of the U.S. Government, a U.S. Government agency, or pre-refunded state and municipal bonds which are 100% backed by U.S. Treasury obligations, no investment in any entity or its affiliates exceeds 10% of shareholders’ equity at September 30, 2011.

At September 30, 2011, ProAssurance has available-for-sale securities with a fair value of $28.6 million on deposit with various state insurance departments to meet regulatory requirements. ProAssurance also has available-for-sale securities with a fair value of $28.3 million that are pledged as collateral security for the 2019 Note Payable (see Note 9).

Business Owned Life Insurance (BOLI)

ProAssurance holds BOLI policies on management employees that are carried at the current cash surrender value of the policies (original cost $35 million). The primary purpose of the program is to offset future employee benefit expenses through earnings on the cash value of the policies. ProAssurance is the owner and principal beneficiary of these policies.

Other Investments

ProAssurance has Other Investments comprised of the following:

(In millions)   

September 30

2011

    

December 31

2010

 
  

 

 

 

Investments in LP/LLCs, at cost; estimated fair value of $33.7 and $37.5, respectively

   $ 28.1       $ 31.2   

FHLB capital stock, at cost

     4.6         5.2   

Other, principally an annuity, at amortized cost

     1.8         1.7   
  

 

 

 
   $ 34.5       $ 38.1   
  

 

 

 

FHLB capital stock is not marketable, but may be liquidated by terminating membership in the FHLB. The liquidation process can take up to five years.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Unconsolidated Subsidiaries

ProAssurance holds investments in unconsolidated subsidiaries, accounted for under the equity method. The investments include the following:

     Carrying Value      Unfunded
Commitments
September 30,
2011
    

Percentage
Ownership

September 30,
2011

(In millions)    September 30,
2011
     December, 31
2010
       
  

 

 

    

 

 

Investment LP/LLCs:

           

Tax Credit Partnerships

   $ 88.4       $ 60.3       $ 57.2       <20%

Long-short Equity Fund

     17.8         18.8         —         <20%

Non-public Equity Fund

     7.0         6.3         —         <20%

Business LLC

     1.3         3.4         —         See below
  

 

 

    

 

 

    
   $ 114.5       $ 88.8       $ 57.2      
  

 

 

    

 

 

    

Investments in Tax Credit Partnerships are comprised of multiple separate limited partnership interests designed to generate investment returns by providing tax benefits to fund investors in the form of project operating losses and tax credits. The related properties are principally low income housing projects.

The Long/Short Equity Fund LP targets absolute returns using a strategy designed to take advantage of event-driven market opportunities.

The Non-public Equity Investment LP holds diversified private equities and is structured to provide capital appreciation.

The Business LLC interest is a convertible preferred interest in a service-related business that began business operations in 2011. The preferred interest can be converted into a non-controlling common interest in May 2015, but conversion is not required.

Investments Held in a Loss Position

The following tables provide summarized information with respect to investments held in an unrealized loss position at September 30, 2011 and December 31, 2010, including the length of time the investment has been held in a continuous unrealized loss position.

     September 30, 2011  
  

 

 

 
     Total     Less than 12 months     More than 12 months  
  

 

 

 
(In thousands)   

Fair

Value

     Unrealized
Loss
   

Fair

Value

     Unrealized
Loss
    Fair
Value
     Unrealized
Loss
 
  

 

 

 

Fixed maturities, available for sale

               

U.S. Treasury obligations

   $ 633       $ (9   $ 633       $ (9   $ —         $ —     

U.S. Agency obligations

     4,730         (16     4,730         (16     —           —     

State and municipal bonds

     10,034         (170     5,112         (26     4,922         (144

Corporate debt

     237,870         (8,738     224,735         (7,371     13,135         (1,367

Residential mortgage-backed securities

     41,651         (2,045     33,867         (351     7,784         (1,694

Commercial mortgage-backed securities

     9,486         (78     6,675         (5     2,811         (73

Other asset-backed securities

     20,001         (25     20,001         (25     —           —     
  

 

 

 
   $ 324,405       $ (11,081   $ 295,753       $ (7,803   $ 28,652       $ (3,278
  

 

 

 

Equity securities, available for sale

   $ —         $ —        $ —         $ —        $ —         $ —     
  

 

 

 

Other investments

               

Investments in LP/LLCs carried at cost of $0.9 million

   $ 729       $ (211   $ 729       $ (211   $ —         $ —     
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

     December 31, 2010  
  

 

 

 
     Total     Less than 12 months     More than 12 months  
  

 

 

 
(In thousands)   

Fair

Value

     Unrealized
Loss
   

Fair

Value

     Unrealized
Loss
    Fair
Value
     Unrealized
Loss
 
  

 

 

 

Fixed maturities, available for sale

               

U.S. Treasury obligations

   $ 61,127       $ (1,242   $ 61,127       $ (1,242   $ —         $ —     

U.S. Agency obligations

     6,340         (39     6,340         (39     —           —     

State and municipal bonds

     199,079         (4,450     191,157         (3,893     7,922         (557

Corporate debt

     287,418         (7,335     275,808         (5,695     11,610         (1,640

Residential mortgage-backed securities

     121,956         (5,114     105,193         (1,927     16,763         (3,187

Commercial mortgage-backed securities

     7,507         (35     6,537         (5     970         (30

Other asset-backed securities

     11,692         (131     11,246         (103     446         (28
  

 

 

 
   $ 695,119       $ (18,346   $ 657,408       $ (12,904   $ 37,711       $ (5,442
  

 

 

 

Equity securities, available for sale

   $ 499       $ (13   $ 335       $ (3   $ 164       $ (10
  

 

 

 

Other investments

               

Investments in LP/LLCs carried at cost of $19.7 million

   $ 19,298       $ (401   $ —         $ —        $ 19,298       $ (401
  

 

 

 

As of September 30, 2011, there are 263 debt securities (10.2% of all available-for-sale fixed maturity securities held) in an unrealized loss position representing 231 issuers. The single greatest unrealized loss position is approximately $1.0 million; the second greatest unrealized loss position is approximately $0.6 million. The securities were evaluated for impairment as of September 30, 2011.

As of December 31, 2010, there were 510 debt securities (19% of all available-for-sale fixed maturity securities held) in an unrealized loss position representing 309 issuers. The single greatest unrealized loss position approximated $0.8 million; the second greatest unrealized loss position approximated $0.6 million. The securities were evaluated for impairment as of December 31, 2010.

Each quarter, ProAssurance performs a detailed analysis for the purpose of assessing whether any of the securities it holds in an unrealized loss position have suffered an other-than-temporary impairment in value. A detailed discussion of the factors considered in the assessment is included in Note 1 of the Notes to the Consolidated Financial Statements included in ProAssurance’s December 31, 2010 Form 10-K.

At September 30, 2011 fixed maturity securities held in an unrealized loss position, excluding asset-backed securities, have paid all scheduled contractual payments and are expected to continue doing so. Expected future cash flows of asset-backed securities held in an unrealized loss position equaled or exceeded the current amortized cost basis of the security; such future cash flows were estimated using the most recently available six-month historical performance data for the collateral (loans) underlying the security or, if historical data was not available, sector based assumptions.

Net Investment Income

Net investment income by investment category is as follows:

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
  

 

 

 
(In thousands)    2011     2010     2011     2010  
  

 

 

 

Fixed maturities

   $ 33,939      $ 35,952      $ 106,573      $ 110,349   

Equities

     569        142        985        597   

Short-term investments

     20        115        93        279   

Other invested assets

     573        548        2,137        2,153   

Business owned life insurance

     635        340        1,571        1,161   
  

 

 

 
     35,736        37,097        111,359        114,539   

Investment expenses

     (1,620     (1,458     (4,786     (4,191
  

 

 

 

Net investment income

   $ 34,116      $ 35,639      $ 106,573      $ 110,348   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Net Realized Investment Gains (Losses)

Net realized investment gains (losses) are comprised of the following:

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
  

 

 

 
(In thousands)    2011     2010     2011     2010  
  

 

 

 

Total other-than-temporary impairment losses:

        

Residential mortgage-backed securities

   $ (13   $ (166   $ (782   $ (189

Other investments

     (1,376     —          (3,509     (3,373

High yield asset-backed securities

     —          (532     —          (9,515

Portion recognized in (reclassified from) Other Comprehensive Income:

        

Residential mortgage-backed securities

     (142     113        (823     119   
  

 

 

 

Net impairment losses recognized in earnings

     (1,531     (585     (5,114     (12,958

Gross realized gains, available-for-sale securities

     1,441        13,213        11,733        23,310   

Gross realized (losses), available-for-sale securities

     (296     (244     (1,653     (445

Net realized gains (losses), short-term

     —          200        —          200   

Net realized gains (losses), trading securities

     (357     26        2,558        4,926   

Change in unrealized holding gains (losses), trading securities

     (11,702     3,360        (13,043     (3,102

Decrease (increase) in the fair value of liabilities carried at fair value

     473        (1,258     (129     (3,124
  

 

 

 

Net realized investment gains (losses)

   $ (11,972   $ 14,712      $ (5,648   $ 8,807   
  

 

 

 

ProAssurance recognized impairments of $3.5 million in 2011 related to an interest in an LLC, accounted for on a cost basis. The LLC has notified ProAssurance of its intention to be sold publicly in the next few months, and the Company has reduced the carrying value of its interest in the LLC to reflect the expected market value of the assets.

ProAssurance recognized credit-related impairments in earnings of $1.6 million in 2011, related to residential mortgage-backed securities. Expected future cash flows were less than ProAssurance’s carrying value for these securities; therefore, ProAssurance reduced the carrying value of its interest in these securities and recognized the loss in its 2011 net income.

The following table presents a roll forward of cumulative credit losses recorded in earnings related to impaired debt securities for which a portion of the other-than-temporary impairment has been recorded in Other Comprehensive Income.

(In thousands)   

Three Months
Ended

September 30, 2011

    

Nine Months

Ended

September 30, 2011

 
  

 

 

 

Balance beginning of period

   $ 5,728       $ 4,446   

Additional credit losses recognized during the period, related to securities for which:

     

No OTTI has been previously recognized

     —           —     

OTTI has been previously recognized

     142         1,424   

Reductions due to:

     

Securities sold during the period (realized)

     —           —     

Securities which will be sold in coming periods

     —           —     

Securities for which it is more likely than not that the security will be required to be sold prior to anticipated recovery of amortized cost basis

     —           —     

Accretion recognized during the period related to cash flows that are expected to exceed the amortized cost basis of the security

     —           —     
  

 

 

 

Balance September 30, 2011

   $ 5,870       $ 5,870   
  

 

 

 

Proceeds from the sales of available-for-sale securities during the three and nine months ended September 30, 2011 are $60.7 million and $371.6 million, respectively, as compared to $232.2 million and $625.5 million for the same respective periods of 2010. Purchases of available-for-sale securities are $144.9 million and $597.8 million during the three and nine months ended September 30, 2011, respectively, as compared to $215.0 million and $673.3 million for the same respective periods of 2010.

 

27


Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

5. Income Taxes

ProAssurance estimates its annual effective tax rate at the end of each quarterly reporting period which is used to record the provision for income taxes in the interim financial statements. The provision for income taxes is different from that which would be obtained by applying the statutory Federal income tax rate to income before taxes primarily because a portion of ProAssurance’s investment income is tax-exempt.

ProAssurance files income tax returns in the U.S. federal jurisdiction and various states. The Internal Revenue Service has completed an examination of the Company’s 2005 through 2008 returns (the 2005-2008 exam) and has begun an examination of the 2009 return. The 2005-2008 exam principally resulted in delaying the deductibility of certain bonus compensation which increased taxes due for the 2007 and 2008 tax years but decreased taxes due for the 2009 tax year by an offsetting amount, the effect of which had previously been recorded as an uncertain tax position. The 2005-2008 exam resulted in no adjustment to tax expense (exclusive of interest accruals) and no penalties or fines. Upon finalization of the 2005-2008 exam, uncertain tax positions totaling $8.3 million were deemed effectively settled and were reversed (along with approximately $324,000 of related accrued interest) in the first quarter of 2011.

ProAssurance’s liability for unrecognized tax benefits is $0.4 million at September 30, 2011 and $8.3 million at December 31, 2010.

6. Deferred Policy Acquisition Costs

Policy acquisition costs, most significantly commissions, premium taxes, and underwriting salaries, that are primarily and directly related to the production of new and renewal premiums are capitalized as policy acquisition costs and amortized to expense as the related premium revenues are earned.

Amortization of deferred policy acquisition costs is $15.5 million and $44.5 million for the three and nine months ended September 30, 2011, respectively, and $14.8 million and $43.9 million for the three and nine months ended September, 2010, respectively.

7. Reserve for Losses and Loss Adjustment Expenses

The reserve for losses is established based on estimates of individual claims and actuarially determined estimates of future losses based on ProAssurance’s past loss experience, available industry data and projections as to future claims frequency, severity, inflationary trends and settlement patterns. Estimating reserves, and particularly liability reserves, is a complex process. Claims may be resolved over an extended period of time, often five years or more, and may be subject to litigation. Estimating losses for liability claims requires ProAssurance to make and revise judgments and assessments regarding multiple uncertainties over an extended period of time. As a result, reserve estimates may vary significantly from the eventual outcome. The assumptions used in establishing ProAssurance’s reserves are regularly reviewed and updated by management as new data becomes available. Changes to estimates of previously established reserves are included in earnings in the period in which the estimate is changed.

ProAssurance recognized favorable net loss development of $52.1 million and $142.3 million related to previously established reserves for the three and nine months ended September 30, 2011, respectively. The favorable net loss development reflects reductions in the Company’s estimates of claims severity, principally for the 2004 through 2009 accident years.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

For the three and nine months ended September 30, 2010, ProAssurance recognized favorable net loss development of $33.4 million and $95.9 million, respectively, to reflect reductions in estimated claim severity principally for accident years 2004 through 2008, offset by a $1.6 million loss on the commutation of a reinsurance agreement.

8. Commitments and Contingencies

ProAssurance is involved in various legal actions related to insurance policies and claims handling including, but not limited to, claims asserted by policyholders. These types of legal actions arise in the Company’s ordinary course of business and, in accordance with GAAP for insurance entities, are considered as a part of the Company’s loss reserving process, which is described in detail under “Accounting Policies - Losses and Loss Adjustment Expenses” in Note 1 of the Notes to the Consolidated Financial Statements in ProAssurance’s 2010 Form 10-K.

As a result of its acquisition of APS, ProAssurance assumed risk of loss related to certain non-claims related legal actions previously asserted against APS subsidiaries. ProAssurance included a liability of $5.6 million related to these actions as a component of the fair value of assets acquired and liabilities assumed in the purchase price allocation. The value of the reserve was based on management’s assessment of the expected outcome of the actions and a reasonable estimate of losses expected to be incurred. The majority of these actions have been resolved during 2011; resolution had no significant effect on operating results. In the best judgment of management, the remaining reserve is adequate to cover the expected ultimate losses of the remaining open litigation.

ProAssurance has commitments to fund approximately $57.2 million in capital contributions to tax credit partnerships as of September 30, 2011. Funding of the commitments is primarily expected to occur in 2011 and 2012; additional information regarding tax credit partnership investments is provided in Note 4. ProAssurance has also entered into agreements with several LP/LLCs, totaling approximately $52.1 million at September 30, 2011, to be funded within the next five years as requested by the partnership.

9. Long-term Debt

ProAssurance’s outstanding long-term debt consists of the following:

     (In thousands)  
    

September 30

2011

     December 31
2010
 
  

 

 

 

Trust Preferred Securities due 2034, unsecured. Bears interest at a variable rate of LIBOR plus 3.85%, adjusted quarterly, set as 4.1% at September 30, 2011.

   $ 22,992       $ 22,992   

Surplus Notes due May 2034, unsecured. Bears interest at a variable rate of LIBOR plus 3.85%, adjusted quarterly, set as 4.2% at September 30, 2011.

     12,000         12,000   

Note Payable due February 2019, carried at fair value, principal of $17.2 million at September 30, 2011 and $17.4 million at December 31, 2010. Secured by available-for-sale securities having a fair value at September 30, 2011 of approximately $28.3 million. Bears interest at a variable rate of LIBOR plus 0.7%. See information below regarding the associated interest rate swap.

     14,411         15,616   

Note Payable due February 2012, unsecured, principal of $517,000 at September 30, 2011 and December 31, 2010. Bears interest at the U.S. prime rate, paid and adjusted quarterly, set as 3.3% at September 30, 2011.

     511         496   
  

 

 

 
   $ 49,914       $ 51,104   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Interest Rate Swap

ProAssurance, through its PICA subsidiary, is party to an interest rate swap agreement (the Swap) with the issuing bank of the Note Payable due February 2019 (the 2019 Note Payable). The purpose of the Swap is to reduce the market risk from changes in future interest rates relative to the 2019 Note Payable. The Swap, which terminates February 1, 2019, effectively fixes the interest rate related to the 2019 Note Payable at 6.6%. The notional amount of the Swap corresponds directly to the unamortized portion of the debt being hedged each month. Under the Swap agreement, PICA agrees to exchange, at monthly intervals, the difference between the fixed-rate and LIBOR variable rate by reference to the notional principal amount. The liability associated with the Swap is measured at fair value on a recurring basis which approximates $4.7 million at September 30, 2011 and $3.7 million at December 31, 2010. The Swap liability is classified as a part of other liabilities.

Revolving Credit Agreement

On April 15, 2011 ProAssurance entered into a revolving credit agreement (the “Agreement”) with five participating lenders. The Agreement permits ProAssurance to borrow, repay and reborrow from the lenders during the term of the Agreement; aggregate outstanding borrowings are not permitted to exceed $150 million at any time. All borrowings are required to be repaid prior to the expiration date of the Agreement (April 15, 2014). ProAssurance is required to pay a commitment fee during the term of the Agreement, ranging from 20 to 40 basis points , based on the average unused portion of the credit line and ProAssurance’s credit ratings, initially set at 25 basis points. The interest rate applicable to borrowings under the Agreement is set at the time funds are borrowed, and is an adjusted rate based on the Eurocurrency rate, if so selected by ProAssurance, or the higher of the Prime rate, the Eurocurrency rate plus 100 basis points, or the Federal Funds rate plus 50 basis points. The amount of the rate adjustment can vary from 0 to 225 basis points, depending upon ProAssurance’s credit ratings at the time funds are borrowed, and on whether the borrowing is secured or unsecured. The Agreement contains customary representations, covenants and events constituting default, and remedies for default. Additionally, the Agreement carries the following financial covenants:

 

  (1) ProAssurance is not permitted to have a leverage ratio of Consolidated Funded Indebtedness (principally, obligations for borrowed money, obligations evidenced by instruments such as notes or acceptances, standby and commercial Letters of Credit, and contingent obligations) to Consolidated Total Capitalization (principally, total non-trade liabilities on a consolidated basis plus consolidated shareholders’ equity, exclusive of accumulated other comprehensive income) greater than 0.35 to 1.0, determined at the end of each fiscal quarter.

 

  (2) ProAssurance is required to maintain a minimum net worth of not less than the sum of 75% of Consolidated Net Worth (consolidated shareholders’ equity, exclusive of accumulated other comprehensive income) at December 31, 2010, plus 50% of consolidated net income earned each fiscal quarter, if positive, beginning with the quarter ending March 31, 2011, plus 100% of net cash proceeds resulting from the issuance of ProAssurance capital stock.

Funds borrowed under the terms of the Revolving Credit Agreement will be used for general corporate purposes, including, but not limited to, use as short-term working capital, funding for share repurchases as authorized by the Board, and for support of other activities ProAssurance enters into in the normal course of business. To date, ProAssurance has not borrowed any funds under the Agreement.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

Covenant Compliance

ProAssurance is currently in compliance with all covenants.

Additional Information

For additional information regarding the terms of ProAssurance’s outstanding long-term debt, see Note 10 of the Notes to the Consolidated Financial Statements included in ProAssurance’s December 31, 2010 Form 10-K.

10. Shareholders’ Equity

At September 30, 2011 and December 31, 2010, ProAssurance had 100 million shares of authorized common stock and 50 million shares of authorized preferred stock. The Board of Directors of ProAssurance Corporation (the Board) has the authority to determine provisions for the issuance of preferred shares, including the number of shares to be issued, the designations, powers, preferences and rights, and the qualifications, limitations or restrictions of such shares. To date, the Board has not approved the issuance of preferred stock.

On September 7, 2011, the Board adopted a cash dividend policy that anticipates a dividend of $1.00 per common share annually, and declared an initial quarterly dividend of $0.25 per common share, $7.6 million in total, to be paid October 13, 2011 to shareholders of record on September 29, 2011. The liability for unpaid dividends is included in Other Liabilities.

At September 30, 2011 approximately $188.4 million in prior authorizations from the Board for the repurchase of common shares or the retirement of outstanding debt remains available for use. The timing and quantity of purchases depends upon market conditions and changes in ProAssurance’s capital requirements and is subject to limitations that may be imposed on such purchases by applicable securities laws and regulations, and the rules of the New York Stock Exchange.

ProAssurance reacquired approximately 341,000 common shares, having a total cost of $21.0 million, during the nine-month period ended September 30, 2011, including approximately 7,000 forfeited employer match shares (cost basis of $0.4 million) reacquired due to the termination of the ProAssurance Corporation Stock Ownership Plan. Approximately 82,000 shares at a total cost of $5.6 million were reacquired during the three-month period ended September 30, 2011. ProAssurance repurchased approximately 1.6 million common shares, having a total cost of $94.4 million, during the nine months ended September 30, 2010 (including approximately 975,000 shares at a total cost of $55.3 million during the three months ended September 30, 2010).

Share-based compensation expense is $1.7 million and $5.4 million for the three and nine months ended September 30, 2011, respectively, and $1.6 million and $4.5 million for the three and nine months ended September 30, 2010, respectively. Related tax benefits are $0.6 million and $1.9 million for the three and nine months ended September 30, 2011, respectively, and $0.6 million and $1.6 million for the three and nine months ended September 30, 2010, respectively.

ProAssurance granted approximately 20,000 restricted share units to employees in February 2011. The awards 100% vest three years from the grant date, based on a continued service requirement. The fair value of each unit was estimated at $64.08, equal to the market value of a ProAssurance common share on the date of grant.

ProAssurance awarded approximately 93,000 (target) performance share units to employees in February 2011. The awards 100% vest at the end of a three-year period if the service requirements are met and minimum performance goals are achieved. If minimum performance goals are achieved, the payment of awards can vary from 75% to 125% of set targets depending upon the degree to which the

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2011

 

performance goals are achieved. The fair value of each award was estimated at $64.08, equal to the market value of a ProAssurance common share on the date of grant. ProAssurance issued approximately 52,000 common shares to employees in February 2011 related to performance share awards granted in 2008. The awards were issued at the maximum level (125% of target) based on performance levels achieved. Cash was given in lieu of shares sufficient to satisfy required tax withholdings.

ProAssurance issued approximately 20,000 and 40,000 common shares to employees in February 2011 and February 2010, respectively, as bonus compensation, as approved by the Compensation Committee of the Board. The shares issued were valued at fair value (the market price of a ProAssurance common share on the date of award).

In late 2010 ProAssurance terminated the ProAssurance Corporation Stock Ownership Plan and established the ProAssurance Corporation 2011 Stock Ownership Plan (the Plan). Under the Plan, eligible employees and directors of ProAssurance and its subsidiaries are given the opportunity to annually contribute up to $5,000 to be used each October for the purchase of ProAssurance common shares. For each share so purchased, ProAssurance will award a matching restricted stock unit to the participant. The restricted stock units will vest at the end of a three-year period subject to a continuous service requirement and be ratably charged to expense over the vesting period.

11. Earnings Per Share

Diluted weighted average shares is calculated as basic weighted average shares plus the effect, calculated using the treasury stock method, of assuming that dilutive stock options have been exercised and that performance share awards and restricted stock units have vested.

Stock options are not dilutive when the option exercise price exceeds the average price of a common share during the period or when the result from assuming an option is exercised is a net decrease to outstanding shares. All outstanding options were dilutive for the three- and nine-month periods ended September 30, 2011, and for the three-month period ended September 30, 2010. Approximately 77,500 of ProAssurance’s outstanding options, on average, were not dilutive for the nine-month period ended September 30, 2010.

12. Variable Interest Entities

ProAssurance holds passive interests in a number of LP/LLCs that are considered to be Variable Interest Entities (VIEs) under GAAP guidance. ProAssurance has not consolidated these entities because it has either very limited or no power to control the activities that most significantly affect the economic performance of these entities and is thus not the primary beneficiary of any of the entities. ProAssurance’s involvement with each entity is limited to its direct ownership interest in the entity. ProAssurance has no arrangements or agreements with any of the entities to provide other financial support to or on behalf of the entity. ProAssurance’s maximum loss exposure relative to these investments is limited to the carrying value of ProAssurance’s investment in the entity.

The entities consist of 1) investments in LP/LLCs formed for the purpose of achieving diversified equity and debt returns, 2) investments in limited partnerships formed to provide investment returns through the transfer of tax credits (principally federal or state tax credits related to federal low-income housing) and 3) a limited liability interest in a development stage business operation. In those instances where ProAssurance holds a minor interest in the entity, ProAssurance accounts for its interest on a cost basis. Cost method investments are included in Other Investments and have a carrying value of $28.1 million and $31.2 million at September 30, 2011 and December 31, 2010, respectively. In those instances where ProAssurance holds a greater than minor interest, ProAssurance accounts for its interest using the equity method. Equity method investments are included in Investment in Unconsolidated Subsidiaries and have a carrying value of $114.5 million at September 30, 2011 and $88.8 million at December 31, 2010.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and Notes to those statements which accompany this report as well as our 2010 Form 10-K. A glossary of insurance terms and phrases is available on the investor section of our website. Throughout the discussion, references to ProAssurance, “PRA,” “Company,” “we,” “us” and “our” refer to ProAssurance Corporation and its consolidated subsidiaries. The discussion contains certain forward-looking information that involves risks and uncertainties. As discussed under “Forward-Looking Statements,” our actual financial condition and operating results could differ significantly from these forward-looking statements.

Critical Accounting Estimates

Our Condensed Consolidated Financial Statements are prepared in conformity with U.S. generally accepted accounting principles (GAAP). Preparation of these financial statements requires us to make estimates and assumptions that affect the amounts we report on those statements. We evaluate these estimates and assumptions on an ongoing basis based on current and historical developments, market conditions, industry trends and other information that we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions; reported results of operations may be materially affected by changes in these estimates and assumptions.

Management considers the following accounting estimates to be critical because they involve significant judgment by management and the effect of those judgments could result in a material effect on our financial statements.

Reserve for Losses and Loss Adjustment Expenses (reserve for losses or reserve)

The largest component of our liabilities is our reserve for losses, and the largest component of expense for our operations is incurred losses. Incurred losses reported in any period reflect our estimate of losses incurred related to the premiums earned in that period as well as any changes to our estimates of the reserve established for losses of prior periods.

The estimation of professional liability losses is inherently difficult and is the subject of significant judgment on the part of management. Loss costs, even for claims with similar characteristics, can vary significantly depending upon many factors, including but not limited to: the nature of the claim and the personal situation of the claimant or the claimant’s family, the outcome of jury trials, the legislative and judicial climate where the insured event occurred, general economic conditions and, for medical professional liability, the trend of health care costs. Professional liability claims are typically resolved over an extended period of time, often five years or more. The combination of changing conditions and the extended time required for claim resolution results in a loss cost estimation process that requires actuarial skill and the application of significant judgment, and such estimates require periodic revision. Our reserves are established by management after taking into consideration a variety of factors including premium rates, claims frequency, historical paid and incurred loss development trends, the effect of inflation, general economic trends, the legal and political environment, and the conclusions reached by our internal and consulting actuaries. We update and review the data underlying the estimation of our reserve for losses each reporting period and make adjustments to loss estimation assumptions that we believe best reflect emerging data. Both our internal and consulting actuaries perform an in-depth review of our reserve for losses on at least a semi-annual basis using the loss and exposure data of our insurance subsidiaries. We engage consulting actuaries to review our data and provide us with their observations regarding our data and the adequacy of our established reserve, believing that the consulting actuaries provide an independent view of our loss data as well as a broader perspective on industry loss trends.

In establishing our initial reserves for a given accident year, due to the lack of data for both open and closed claims available for that accident year, we rely significantly on the many loss assumptions that are used in our pricing models, plus an additional 8 to 10 percentage points we believe necessary to bring our pricing models and resulting loss reserves in line with historical loss experience. We believe that this is initially warranted given inherent risks associated with our rate development process and the historic volatility of professional liability losses (the industry has experienced accident year loss ratios as high as 163% and as low as 57% over the past 30 years). Our current pricing model assumes a severity trend (i.e., annual increase in

 

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the average costs of claims settlement) of 4%. If the severity trend were to be higher by one percentage point the impact would be an increase in our expected loss ratio of 3.2 percentage points. An increase in the severity trend of three percentage points would result in a 10.1 percentage point increase in our expected loss ratio. For all these reasons, management believes establishing reserves 8 to 10 percentage points above its pricing targets provides a reasonable best estimate of our reserves to cover actual ultimate unpaid losses. In the current environment this equates to an initial loss ratio of approximately 85% as compared to a 75% loss ratio assumed in our pricing.

Given the long-tailed nature of our business and the historical volatility of loss costs as discussed above, we are cautious in giving full credibility to emerging trends that, when more fully mature, may lead to the recognition of favorable and/or adverse development of our losses. Frequently there may be trends, both positive and negative, reflected in the numerical data both within the Compa