10-Q 1 d311225d10q.htm 10-Q 10-Q
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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 March 31, 2012 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 April 30, 2012, there were 30,649,575 shares of the registrant’s common stock outstanding.

 

 

 


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TABLE OF CONTENTS

 

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

     28   

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     52   

ITEM 4. CONTROLS AND PROCEDURES

     54   

PART II. OTHER INFORMATION

     55   

ITEM 1. LEGAL PROCEEDINGS

     55   

ITEM 1A. RISK FACTORS

     55   

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

     55   

ITEM 6. EXHIBITS

     56   

SIGNATURE

     57   


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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;

 

   

our ability to maintain our dividend payments;

 

   

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 or to 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 healthcare delivery system, including but not limited to the Patient Protection and Affordable Care Act;

 

   

consolidation of healthcare providers and entities that are more likely to self insure and not purchase medical professional liability insurance;

 

   

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;

 

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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;

 

   

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;

 

   

provisions in our charter documents, Delaware law and state insurance law may impede attempts to replace or remove management or may impede a takeover;

 

   

state insurance restrictions may prohibit assets held by our insurance subsidiaries, including cash and investment securities, from being used for general corporate purposes;

 

   

taxing authorities can take exception to our tax positions and cause us to incur significant amounts of defense costs and, if our defense is not successful, additional tax costs, including interest and penalties;

 

   

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

 

   

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 are based upon conditions existing 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.

 

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ProAssurance Corporation and Subsidiaries

Condensed Consolidated Balance Sheets (Unaudited)

(In thousands, except share data)

 

    

March 31

2012

   

December 31

2011

 
  

 

 

 

Assets

    

Investments

    

Fixed maturities, available for sale, at fair value; amortized cost, $3,458,213 and $3,465,720, respectively

   $ 3,662,886      $ 3,665,763   

Equity securities, available for sale, at fair value; cost, $5 and $6, respectively

     27        25   

Equity securities, trading, at fair value; cost, $112,493 and $101,078, respectively

     122,486        103,133   

Short-term investments

     132,739        119,421   

Business owned life insurance

     53,115        52,651   

Investment in unconsolidated subsidiaries

     116,020        111,324   

Other investments

     37,645        38,224   
  

 

 

 

Total Investments

     4,124,918        4,090,541   

Cash and cash equivalents

     120,430        130,400   

Premiums receivable

     130,310        120,220   

Receivable from reinsurers on paid losses and loss adjustment expenses

     10,071        4,175   

Receivable from reinsurers on unpaid losses and loss adjustment expenses

     245,984        247,658   

Prepaid reinsurance premiums

     14,075        12,568   

Deferred policy acquisition costs

     27,548        26,626   

Deferred taxes

     26,844        30,989   

Real estate, net

     40,381        40,432   

Intangible assets

     52,463        53,703   

Goodwill

     159,625        159,625   

Other assets

     80,679        81,941   
  

 

 

 

Total Assets

   $ 5,033,328      $ 4,998,878   
  

 

 

 

Liabilities and Shareholders’ Equity

    

Liabilities

    

Policy liabilities and accruals

    

Reserve for losses and loss adjustment expenses

   $ 2,234,758      $ 2,247,772   

Unearned premiums

     273,844        251,155   

Reinsurance premiums payable

     90,599        82,039   
  

 

 

 

Total Policy Liabilities

     2,599,201        2,580,966   

Other liabilities

     167,382        203,772   

Long-term debt, $34,992 and $35,507, at amortized cost, respectively; $14,962 and $14,180 at fair value, respectively

     49,954        49,687   
  

 

 

 

Total Liabilities

     2,816,537        2,834,425   

Shareholders’ Equity

    

Common shares, par value $0.01 per share, 100,000,000 shares authorized, 34,647,526 and 34,551,494 shares issued, respectively

     346        346   

Additional paid-in capital

     539,969        538,625   

Accumulated other comprehensive income (loss), net of deferred tax expense (benefit) of $71,644 and $70,022, respectively

     133,049        130,037   

Retained earnings

     1,747,835        1,699,853   
  

 

 

 
     2,421,199        2,368,861   

Treasury shares, at cost, 3,997,951 shares

     (204,408     (204,408
  

 

 

 

Total Shareholders’ Equity

     2,216,791        2,164,453   
  

 

 

 

Total Liabilities and Shareholders’ Equity

   $ 5,033,328      $ 4,998,878   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

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, 2011

   $ 2,164,453      $ 130,037      $ 1,699,853      $ 334,563   

Net income

     55,645        —          55,645        —     

Dividends to shareholders

     (7,663     —          (7,663     —     

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

     3,012        3,012        —          —     

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

     (786     —          —          (786

Share-based compensation

     2,130        —          —          2,130   
  

 

 

 

Balance at March 31, 2012

   $ 2,216,791      $ 133,049      $ 1,747,835      $ 335,907   
  

 

 

 
     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

     47,693        —          47,693        —     

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

     (4,291     (4,291     —          —     

Common shares reacquired

     (14,993     —          —          (14,993

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

     (1,269     —          —          (1,269

Share-based compensation

     1,737        —          —          1,737   
  

 

 

 

Balance at March 31, 2011

   $ 1,884,740      $ 74,833      $ 1,475,719      $ 334,188   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Income and Comprehensive Income (Unaudited)

(In thousands, except per share data)

 

    

Three Months Ended

March 31

 
  

 

 

 
     2012     2011  
  

 

 

 

Revenues

    

Net premiums earned

   $ 136,659      $ 132,077   

Net investment income

     33,492        36,161   

Equity in earnings (loss) of unconsolidated subsidiaries

     (2,066     (1,364

Net realized investment gains (losses):

    

Other-than-temporary impairment (OTTI) losses

     (1,206     (1,837

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

     —          (568
  

 

 

 

Net impairment losses recognized in earnings

     (1,206     (2,405

Other net realized investment gains (losses)

     11,883        6,529   
  

 

 

 

Total net realized investment gains (losses)

     10,677        4,124   

Other income

     1,809        2,587   
  

 

 

 

Total revenues

     180,571        173,585   
  

 

 

 

Expenses

    

Losses and loss adjustment expenses

     78,305        77,101   

Reinsurance recoveries

     (8,106     (6,678
  

 

 

 

Net losses and loss adjustment expenses

     70,199        70,423   

Underwriting, policy acquisition and operating expenses

     34,398        35,709   

Interest expense

     825        795   
  

 

 

 

Total expenses

     105,422        106,927   
  

 

 

 

Income before income taxes

     75,149        66,658   

Provision for income taxes

    

Current expense (benefit)

     16,981        5,059   

Deferred expense (benefit)

     2,523        13,906   
  

 

 

 

Total income tax expense (benefit)

     19,504        18,965   
  

 

 

 

Net income

   $ 55,645      $ 47,693   

Other comprehensive income, after tax, net of reclassification adjustments (see Note 9)

     3,012        (4,291
  

 

 

 

Comprehensive income

   $ 58,657      $ 43,402   
  

 

 

 

Earnings per share:

    

Basic

   $ 1.82      $ 1.56   
  

 

 

 

Diluted

   $ 1.80      $ 1.55   
  

 

 

 

Weighted average number of common shares outstanding:

    

Basic

     30,589        30,616   
  

 

 

 

Diluted

     30,852        30,853   
  

 

 

 

Cash dividends declared per common share

   $ 0.25      $ —     
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

 

     Three Months Ended
March 31
 
  

 

 

 
     2012     2011  
  

 

 

 

Operating Activities

    

Net income

   $ 55,645      $ 47,693   

Depreciation and amortization

     10,382        9,115   

Net realized investment (gains) losses

     (10,677     (4,124

Share-based compensation

     2,130        1,737   

Deferred income taxes

     2,523        13,906   

Other

     (2,588     (757

Changes in assets and liabilities:

    

Premiums receivable

     (10,090     (2,678

Other assets

     (2,920     650   

Reserve for losses and loss adjustment expenses

     (13,014     (2,742

Unearned premiums

     22,689        19,548   

Reinsurance related assets and liabilities

     2,831        (9,242

Other liabilities

     (28,811     (48,245
  

 

 

 

Net cash provided by operating activities

     28,100        24,861   
  

 

 

 

Investing Activities

    

Purchases of:

    

Fixed maturities, available for sale

     (247,622     (252,043

Equity securities, trading

     (26,678     (15,750

Other investments

     (158     —     

(Investments in) distributions from unconsolidated subsidiaries, net:

    

Tax credit limited partnerships

     (12,236     (6,228

Other partnership investments

     —          —     

Proceeds from sale or maturities of:

    

Fixed maturities, available for sale

     252,234        211,573   

Equity securities, available for sale

     —          3,589   

Equity securities, trading

     16,039        18,621   

Other investments

     486        —     

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

     (13,143     22,948   

Unsettled security transactions, net

     4,403        30,320   

Cash received (paid) for other assets

     (1,358     (12,227
  

 

 

 

Net cash provided (used) by investing activities

     (28,033     803   
  

 

 

 

Financing Activities

    

Repurchase of common stock

     —          (14,993

Dividend to shareholders

     (7,622     —     

Other

     (2,415     (2,018
  

 

 

 

Net cash provided (used) by financing activities

     (10,037     (17,011
  

 

 

 

Increase (decrease) in cash and cash equivalents

     (9,970     8,653   

Cash and cash equivalents at beginning of period

     130,400        50,851   
  

 

 

 

Cash and cash equivalents at end of period

   $ 120,430      $ 59,504   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

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 period ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. The accompanying Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes contained in ProAssurance’s December 31, 2011 report on Form 10-K. In connection with its preparation of the Condensed Consolidated Financial Statements, ProAssurance evaluated events that occurred subsequent to March 31, 2012 for recognition or disclosure in its financial statements and notes to financial statements.

Accounting Changes Not Yet Adopted

Disclosures About Offsetting Assets and Liabilities

Effective for fiscal years beginning on or after January 1, 2013, the Financial Accounting Standards Board (FASB) revised guidance related to disclosures about certain assets and liabilities in an entity’s financial statements. The guidance requires disclosures related to the net and gross positions of certain financial instruments and transactions that are either eligible for offset in accordance with existing GAAP guidance or subject to an agreement that requires such offset. The guidance must be applied retrospectively for all prior periods presented. ProAssurance plans to adopt the guidance beginning January 1, 2013. Adoption of this guidance is not expected to have a material effect on ProAssurance’s results of operations or financial position.

Accounting Changes

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 only when associated 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 prospectively adopted the guidance on January 1, 2012. Adoption of this guidance 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, 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

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

1. Basis of Presentation (continued)

 

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 adopted the guidance on January 1, 2012. Adoption of this guidance had no material effect on ProAssurance’s results of operations or financial position.

2. 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 March 31, 2012 and December 31, 2011 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)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

Assets and liabilities measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011, including financial instruments for which ProAssurance has elected fair value accounting, are as follows:

 

 

     March 31, 2012  
  

 

 

 
     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

   $ —         $ 249,281       $ —         $ 249,281   

U.S. Agency obligations

     —           69,883         —           69,883   

State and municipal bonds

     —           1,219,500         7,175         1,226,675   

Corporate debt, multiple observable inputs

     —           1,420,912         —           1,420,912   

Corporate debt, limited observable inputs:

           

Private placement senior notes

     —           —           605         605   

Other corporate debt, NRSRO ratings available

     —           —           6,959         6,959   

Other corporate debt, NRSRO ratings not available

     —           —           1,125         1,125   

Residential mortgage-backed securities

     —           513,030         —           513,030   

Commercial mortgage-backed securities

     —           77,819         —           77,819   

Other asset-backed securities

     —           96,597         —           96,597   

Equity securities

           

Financial

     33,423         —           —           33,423   

Energy

     15,492         —           —           15,492   

Consumer oriented

     33,448         —           —           33,448   

Technology

     8,825         —           —           8,825   

Industrial

     13,866         —           —           13,866   

All other

     17,459         —           —           17,459   

Short-term investments

     124,723         8,016         —           132,739   

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

           

Investment in unconsolidated subsidiaries

     —           —           24,430         24,430   

Other investments

     —           —           15,742         15,742   
  

 

 

 

Total assets

   $ 247,236       $ 3,655,038       $ 56,036       $ 3,958,310   
  

 

 

 

Liabilities:

           

2019 Note payable

     —           —           14,962         14,962   

Interest rate swap agreement

     —           —           4,415         4,415   
  

 

 

 

Total liabilities

   $ —         $ —         $ 19,377       $ 19,377   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

     December 31, 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

   $ —         $ 283,865       $ —         $ 283,865   

U.S. Agency obligations

     —           68,104         —           68,104   

State and municipal bonds

     —           1,221,187         7,200         1,228,387   

Corporate debt, multiple observable inputs

     —           1,359,866         —           1,359,866   

Corporate debt, limited observable inputs:

           

Private placement senior notes

     —           —           612         612   

Other corporate debt, NRSRO ratings available

     —           —           6,310         6,310   

Other corporate debt, NRSRO ratings not available

     —           —           1,160         1,160   

Residential mortgage-backed securities

     —           542,551         —           542,551   

Commercial mortgage-backed securities

     —           81,188         —           81,188   

Other asset-backed securities

     —           93,720         —           93,720   

Equity securities

           

Financial

     25,281         —           —           25,281   

Energy

     13,381         —           —           13,381   

Consumer oriented

     29,711         —           —           29,711   

Technology

     7,556         —           —           7,556   

Industrial

     9,185         —           —           9,185   

All other

     18,044         —           —           18,044   

Short-term investments

     111,359         8,062         —           119,421   

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

           

Investment in unconsolidated subsidiaries

     —           —           23,841         23,841   

Other investments

     —           —           15,873         15,873   
  

 

 

 

Total assets

   $ 214,517       $ 3,658,543       $ 54,996       $ 3,928,056   
  

 

 

 

Liabilities:

           

2019 Note payable

     —           —           14,180         14,180   

Interest rate swap agreement

     —           —           4,659         4,659   
  

 

 

 

Total liabilities

   $ —         $ —         $ 18,839       $ 18,839   
  

 

 

 

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 data among pricing services and to available market and trade data. Values that appear inconsistent are further reviewed for appropriateness. 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 2012 or 2011.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

Level 2 Valuations

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.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

Level 3 Valuations

Below is a summary description of the valuation processes and methodologies used as well as quantitative information regarding securities in the Level 3 category.

Level 3 Valuation Processes

 

   

Level 3 securities are priced by the Company’s Vice President of Investments, who reports to the Chief Financial Officer.

 

   

Level 3 valuations are computed quarterly. Prices are evaluated quarterly against prior period prices and the expected change in price.

 

   

The Company’s Level 3 valuations are not overly sensitive to changes in the unobservable inputs used. The securities noted in the disclosure are primarily investment grade debt where comparable market inputs are commonly available for evaluating the securities in question.

Level 3 Valuation Methodologies

State and municipal bonds consists of auction rate municipal bonds valued internally using published quotes for similar securities or by 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.

Corporate debt with limited observable inputs consists of private placement senior notes guaranteed by large regional banks and corporate bonds. Valuations are determined 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 March 31, 2012, the average NRSRO rating of rated securities is BBB.

Investments in unconsolidated subsidiaries and Other investments consist of limited partnership (LP) and limited liability company (LLC) interests valued using net asset values (NAVs) provided by the LP/LLC, which approximates the fair value of the interest. Such interests include the following:

 

 

December 31, December 31, December 31,
     Fair Value      Unfunded
Commitments
  

 

 

(In thousands)   

March 31,

2012

    

December 31,

2011

    

March 31,

2012

  

 

 

Investment in unconsolidated subsidiaries:

        

LP primarily invested in long/short equities (1)

   $ 17,505       $ 17,123       None

LP primarily invested in non-public equities (2)

     6,925         6,718       $3,500
  

 

 

    
     24,430         23,841      

Other investments:

        

LLC primarily invested in private equity and debt (3)

     15,742         15,873       None
  

 

 

    
   $ 40,172       $ 39,714      
  

 

 

    

 

(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.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

(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. The LLC converted into a publicly traded investment fund in April 2012. Due to conversion restrictions, ProAssurance cannot sell its interest in the fund before October 2012.

Liabilities (the 2019 Note payable and the Interest rate swap agreement) are valued using the present value of expected underlying cash flows of the instrument, discounted at rates available on the valuation date for similar instruments issued by entities with a similar credit standing to ProAssurance.

Quantitative Information Regarding Level 3 Valuations

 

 

Quantitative information about Level 3 Fair Value Measurements
($ in millions)   

Fair Value at

March 31, 2012

     Valuation Technique    Unobservable Input   

Range

(Weighted Range)

Assets:

           

State and municipal bonds

   $ 7.2       Market Comparable Securities    Comparability Adjustment    0% - 10% (5%)
      Discounted Cash Flows    Comparability Adjustment    0% - 10% (5%)

Corporate debt with limited observable inputs

   $ 8.7       Market Comparable Securities    Comparability Adjustment    0% - 5% (2.5%)
      Discounted Cash Flows    Comparability Adjustment    0% - 5% (2.5%)

Liabilities:

           

2019 Note payable, Interest rate swap agreement

   $ 19.4       Discounted Cash Flows    Comparability Adjustment    0% - 5% (2.5%)

The significant unobservable inputs used in the fair value measurement of the entity’s corporate bonds are the valuations of comparable securities with similar issuer, credit quality and maturity. Changes in the availability of comparable securities could result in changes in the fair value measurements.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

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.

 

 

     March 31, 2012  
     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, 2011

   $ 7,200      $ 8,082       $ —         $ 23,841       $ 15,873      $ 54,996   

Total gains (losses) realized and unrealized:

               

Included in earnings, as a part of:

               

Equity in earnings of unconsolidated subsidiaries

     —          —           —           589         —          589   

Net realized investment gains (losses)

     —          —           —           —           (131     (131

Included in other comprehensive income

     —          607         —           —           —          607   

Purchases

     —          —           —           —           —          —     

Sales

     (25     —           —           —           —          (25

Transfers in

     —          —           —           —           —          —     

Transfers out

     —          —           —           —           —          —     
  

 

 

 

Balance March 31, 2012

   $ 7,175      $ 8,689       $ —         $ 24,430       $ 15,742      $ 56,036   
  

 

 

 

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

   $ —        $ —         $ —         $ 589       $ (131   $ 458   
  

 

 

 

 

     March 31, 2011  
     Level 3 Fair Value Measurements – Assets  
(In thousands)   

State and

Municipal

Bonds

    Corporate
Bonds
   

Asset-
backed

Securities

    Investment in
Unconsolidated
Subsidiaries
     Other
Investments
     Total  
  

 

 

 

Assets

              

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

     —          —          —          550         —           550   

Net realized investment gains (losses)

     —          —          314        —           —           314   

Included in other comprehensive income

     —          (180     (15     —           —           (195

Purchases

     —          —          —          —           —           —     

Sales

     (100     (5,195     (1,921     —           —           (7,216

Transfers in

     —          3,447        —          —           —           3,447   

Transfers out

     —          (2,421     (598     —           —           (3,019
  

 

 

 

Balance March 31, 2011

   $ 7,450      $ 16,880      $ —        $ 25,662       $ —         $ 49,992   
  

 

 

 

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

   $ —        $ —        $ —        $ 550       $ —         $ 550   
  

 

 

 

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

Transfers

There were no transfers between the Level 1 and Level 2 categories during the three months ended March 31, 2012 or 2011.

There were no transfers in or out of Level 3 during the three months ended March 31, 2012. The transfers shown during the three months ended March 31, 2011 relate to securities held for which there was little market activity for identical or nearly identical securities during the period and represent transfers to or from Level 2. Such securities are valued using multiple observable inputs when those inputs are available; otherwise the securities are valued using limited observable inputs.

 

 

     March 31, 2012  
             Level 3 Fair Value  Measurements - Liabilities          
(In thousands)   

2019

Note

Payable

   

Interest

rate swap
agreement

    Total  
  

 

 

 

Balance December 31, 2011

   $ 14,180      $ 4,659      $ 18,839   

Total (gains) losses realized and unrealized:

      

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

     868        (244     624   

Settlements

     (86     —          (86
  

 

 

 

Balance March 31, 2012

   $ 14,962      $ 4,415      $ 19,377   
  

 

 

 

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

   $ 868      $ (244   $ 624   
  

 

 

 
     March 31, 2011  
     Level 3 Fair Value Measurements - Liabilities  
(In thousands)   

2019

Note

Payable

   

Interest

rate swap
agreement

    Total  
  

 

 

 

Liabilities

      

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

     19        (243     (224

Settlements

     (80     —          (80
  

 

 

 

Balance March 31, 2011

   $ 15,555      $ 3,415      $ 18,970   
  

 

 

 

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

   $ 19      $ (243   $ (224
  

 

 

 

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)

March 31, 2012

 

2. Fair Value Measurement (continued)

 

Financial Instruments Not Measured At Fair Value

The following table provides the estimated fair value of our financial instruments that are not carried at fair value. All fair values provided fall within the Level 3 fair value category.

 

 

     March 31, 2012      December 31, 2011  
  

 

 

    

 

 

 
(In thousands)   

Carrying

Value

    

Estimated

Fair

Value

    

Carrying

Value

    

Estimated

Fair

Value

 
  

 

 

    

 

 

 

Financial assets:

           

Other investments

   $ 21,903       $ 29,608       $ 22,351       $ 28,226   

Investment in unconsolidated subsidiaries

     91,590         101,144         87,483         96,443   

BOLI

     53,115         53,115         52,651         52,651   

Other assets

     10,491         10,491         9,636         9,636   

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

     —           —           515         519   

Other liabilities

     14,500         14,410         15,076         14,946   

Other Investments listed in the table above include interests in certain investment fund LPs/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 estimated fair value of the FHLB common stock is based on the amount ProAssurance would receive if its membership were canceled, as 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 a non-controlling interest in a 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 LLC interest is estimated as the proceeds ProAssurance would receive upon liquidation of the LLC.

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. Other Liabilities also includes certain contractual liabilities assumed as a part of a business combination. Fair values of the funded deferred compensation assets/liabilities are based on the NAVs 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)

March 31, 2012

 

3. Investments

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

 

 

     March 31, 2012  
  

 

 

 
(In thousands)   

Amortized

Cost

    

Gross

Unrealized

Gains

    

Gross

Unrealized

Losses

   

Estimated

Fair

Value

 
  

 

 

 

Fixed maturities

          

U.S. Treasury obligations

   $ 234,249       $ 15,094       $ (62   $ 249,281   

U.S. Agency obligations

     64,454         5,429         —          69,883   

State and municipal bonds

     1,146,835         80,459         (619     1,226,675   

Corporate debt

     1,358,665         74,747         (3,811     1,429,601   

Residential mortgage-backed securities

     486,279         28,701         (1,950 )*      513,030   

Commercial mortgage-backed securities

     72,322         5,554         (57     77,819   

Other asset-backed securities

     95,409         1,197         (9     96,597   
  

 

 

 
     3,458,213         211,181         (6,508     3,662,886   

Equity securities

     5         22         —          27   
  

 

 

 
   $ 3,458,218       $ 211,203       $ (6,508   $ 3,662,913   
  

 

 

 

 

     December 31, 2011  
  

 

 

 
(In thousands)   

Amortized

Cost

    

Gross

Unrealized

Gains

    

Gross

Unrealized

Losses

   

Estimated

Fair

Value

 
  

 

 

 

Fixed maturities

          

U.S. Treasury obligations

   $ 267,120       $ 16,748       $ (3   $ 283,865   

U.S. Agency obligations

     62,520         5,584         —          68,104   

State and municipal bonds

     1,145,025         83,568         (206     1,228,387   

Corporate debt

     1,307,504         68,105         (7,661     1,367,948   

Residential mortgage-backed securities

     514,412         30,270         (2,131 )*      542,551   

Commercial mortgage-backed securities

     76,366         4,881         (59     81,188   

Other asset-backed securities

     92,773         978         (31     93,720   
  

 

 

 
     3,465,720         210,134         (10,091     3,665,763   

Equity securities

     6         19         —          25   
  

 

 

 
   $ 3,465,726       $ 210,153       $ (10,091   $ 3,665,788   
  

 

 

 

 

* Includes other-than-temporary impairments recognized in accumulated other comprehensive income of $3.3 million at both March 31, 2012 and December 31, 2011.

 

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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

3. Investments (continued)

 

The recorded cost basis and estimated fair value of available-for-sale fixed maturities at March 31, 2012, 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

   $ 234,249       $ 16,799       $ 150,674       $ 78,005       $ 3,803       $ 249,281   

U.S. Agency obligations

     64,454         6,767         38,621         24,233         262         69,883   

State and municipal bonds

     1,146,835         38,292         358,818         548,871         280,694         1,226,675   

Corporate debt

     1,358,665         97,969         691,217         605,732         34,683         1,429,601   

Residential mortgage-backed securities

     486,279                     513,030   

Commercial mortgage-backed securities

     72,322                     77,819   

Other asset-backed securities

     95,409                     96,597   
  

 

 

                

 

 

 
   $ 3,458,213                   $ 3,662,886   
  

 

 

                

 

 

 

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 March 31, 2012.

At March 31, 2012, ProAssurance has available-for-sale securities with a fair value of $21.9 million on deposit with various state insurance departments to meet regulatory requirements. ProAssurance also has available-for-sale securities with a fair value of $29.8 million that are pledged as collateral security for the 2019 Note Payable (see Note 8).

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)   

March 31,

2012

    

December 31,

2011

 
  

 

 

 

Investment in LLC, at NAV

   $ 15.7       $ 15.9   

Investments in LPs/LLCs, at cost

     15.9         16.2   

FHLB capital stock, at cost

     4.4         4.4   

Other, principally an annuity, at amortized cost

     1.6         1.7   
  

 

 

 
   $ 37.6       $ 38.2   
  

 

 

 

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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ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

3. Investments (continued)

 

Unconsolidated Subsidiaries

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

 

 

     Carrying Value     

Unfunded
Commitments
March 31,

2012

    

Percentage
Ownership

March 31,

2012

(In millions)    March 31,
2012
    

December 31,

2011

       
  

 

 

    

 

 

Investment LPs/LLCs:

           

Tax Credit Partnerships

   $ 91.4       $ 86.8       $ 43.8       <20%

Long/Short Equity Fund

     17.5         17.1         —         <20%

Non-public Equity Fund

     6.9         6.7         3.5       <20%

Business LLC

     0.2         0.7         —         See below
  

 

 

    

 

 

    
   $ 116.0       $ 111.3       $ 47.3      
  

 

 

    

 

 

    

Investments in Tax Credit Partnerships are comprised of multiple separate LP/LLC 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 Fund 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 March 31, 2012 and December 31, 2011, including the length of time the investment has been held in a continuous unrealized loss position.

 

 

     March 31, 2012  
  

 

 

 
     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

   $ 16,404       $ (62   $ 16,404       $ (62   $ —         $ —     

State and municipal bonds

     37,781         (619     35,599         (523     2,182         (96

Corporate debt

     188,772         (3,811     171,595         (2,910     17,177         (901

Residential mortgage-backed securities

     32,597         (1,950     20,327         (651     12,270         (1,299

Commercial mortgage-backed securities

     3,234         (57     1,892         (1     1,342         (56

Other asset-backed securities

     12,026         (9     12,026         (9     —           —     
  

 

 

 
   $ 290,814       $ (6,508   $ 257,843       $ (4,156   $ 32,971       $ (2,352
  

 

 

 

Other investments

               

Investments in LPs/LLCs carried at cost

   $ 6,223       $ (290   $ 5,824       $ (178   $ 399       $ (112
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

3. Investments (continued)

 

     December 31, 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

   $ 8,379       $ (3   $ 8,379       $ (3   $ —         $ —     

State and municipal bonds

     9,743         (206     7,143         (10     2,600         (196

Corporate debt

     205,605         (7,661     194,057         (6,691     11,548         (970

Residential mortgage-backed securities

     49,525         (2,131     38,146         (488     11,379         (1,643

Commercial mortgage-backed securities

     4,086         (59     3,143         (2     943         (57

Other asset-backed securities

     19,031         (31     19,031         (31     —           —     
  

 

 

 
   $ 296,369       $ (10,091   $ 269,899       $ (7,225   $ 26,470       $ (2,866
  

 

 

 

Other investments

               

Investments in LPs/LLCs carried at cost

   $ 4,198       $ (984   $ 3,815       $ (856   $ 383       $ (128
  

 

 

 

As of March 31, 2012, there are 192 debt securities (7.3% of all available-for-sale fixed maturity securities held) in an unrealized loss position representing 177 issuers. The single greatest unrealized loss position is approximately $0.9 million; the second greatest unrealized loss position is approximately $0.4 million. The securities were evaluated for impairment as of March 31, 2012.

As of December 31, 2011, there were 251 debt securities (9.6% of all available-for-sale fixed maturity securities held) in an unrealized loss position representing 224 issuers. The single greatest unrealized loss position approximated $1.2 million; the second greatest unrealized loss position approximated $1.0 million. The securities were evaluated for impairment as of December 31, 2011.

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 Consolidated Financial Statements included in ProAssurance’s December 31, 2011 Form 10-K.

At March 31, 2012, 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

March 31

 
  

 

 

 
(In thousands)    2012     2011  
  

 

 

 

Fixed maturities

   $ 33,270      $ 35,951   

Equities

     1,041        230   

Short-term investments

     19        55   

Other invested assets

     402        992   

Business owned life insurance

     457        464   
  

 

 

 
     35,189        37,692   

Investment expenses

     (1,697     (1,531
  

 

 

 

Net investment income

   $ 33,492      $ 36,161   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

3. Investments (continued)

 

Net Realized Investment Gains (Losses)

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

 

 

    

Three Months Ended

March 31

 
  

 

 

 
(In thousands)    2012     2011  
  

 

 

 

Total other-than-temporary impairment losses:

    

Residential mortgage-backed securities

   $ (245   $ (450

Corporate debt

     (830     —     

Other investments

     (131     (1,387

Portion recognized in (reclassified from) Other Comprehensive Income:

    

Residential mortgage-backed securities

     —          (568
  

 

 

 

Net impairment losses recognized in earnings

     (1,206     (2,405

Gross realized gains, available-for-sale securities

     3,887        4,628   

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

     (94     (244

Net realized gains (losses), trading securities

     777        2,692   

Change in unrealized holding gains (losses), trading securities

     7,937        (771

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

     (624     224   
  

 

 

 

Net realized investment gains (losses)

   $ 10,677      $ 4,124   
  

 

 

 

ProAssurance recognized credit-related impairments of $0.8 million during the first three months of 2012 related to a corporate debt security due to deterioration of the credit standing of the issuer during the first quarter of 2012.

ProAssurance recognized impairments of $0.1 million and $1.4 million during the three months ended March 31, 2012 and 2011, respectively, related to an interest in an LLC which is accounted for using the cost method. The LLC announced plans to convert into a publicly traded investment fund during the first quarter of 2011 and completed the conversion in April 2012. In both 2012 and 2011, ProAssurance recognized impairments in order to reduce the carrying value of its interest in the LLC to fair value, based upon the NAV most recently reported by the fund.

ProAssurance recognized credit-related impairments in earnings of $0.2 million and $1.0 million during the first three months of 2012 and 2011, respectively, related to certain residential mortgage-backed securities because the expected discounted future cash flows from the securities were less than the carrying value for the securities.

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.

 

    

Three Months Ended

March 31

 
  

 

 

 
(In thousands)    2012      2011  
  

 

 

 

Balance January 1

   $ 5,870       $ 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

     67         888   

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 March 31

   $ 5,937       $ 5,334   
  

 

 

 

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

3. Investments (continued)

 

Other information regarding sales and purchases of available-for-sale securities are as follows:

 

 

     Three Months Ended
March  31
 
(In millions)    2012      2011  
  

 

 

 

Proceeds from sales (exclusive of maturities and paydowns)

   $ 206.1       $ 169.5   

Purchases of other available-for-sale securities

   $ 247.6       $ 252.0   

4. 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.

The Internal Revenue Service has begun but has not completed an examination of the 2009 and 2010 returns. Except for the 2006 tax year, the statutes of limitation are closed for all years prior to 2008. The statute for the 2006 tax year has been extended from May 31, 2012 to September 15, 2013.

ProAssurance’s liability for unrecognized tax benefits, exclusive of accrued interest, is $23.7 million at March 31, 2012 and $18.6 million at December 31, 2011 with the increase in the provision being entirely attributable to unrecognized benefits associated with tax positions taken in a prior year. Unrecognized tax benefits at March 31, 2012 and December 31, 2011, if recognized, would not affect the effective tax rate but would accelerate the payment of tax. As with any uncertain tax position, there is a possibility that the ultimate deduction recognized could differ from the provision ProAssurance has established.

5. Deferred Policy Acquisition Costs

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

As of January 1, 2012, policy acquisition costs related to unsuccessful contracts are expensed immediately as a result of the revised FASB guidance as discussed in Note 1. ProAssurance adopted the revised guidance on a prospective basis. Under prior guidance, policy acquisition costs capitalized during the three months ended March 31, 2012 would have been $17.1 million as compared to $16.0 million capitalized under the revised guidance.

Amortization of deferred policy acquisition costs is $15.1 million and $14.4 million for the three months ended March 31, 2012 and 2011, respectively.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

6. 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 $47.5 million related to previously established reserves for the three months ended March 31, 2012. The favorable net loss development reflects reductions in the Company’s estimates of claims severity, principally for the 2004 through 2009 accident years.

For the three months ended March 31, 2011, ProAssurance recognized favorable net loss development of $40.0 million, to reflect reductions in estimated claim severity principally for accident years 2004 through 2008.

7. 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 2011 Form 10-K.

ProAssurance has commitments to fund approximately $44 million in capital contributions to tax credit partnerships as of March 31, 2012. Funding of the commitments is primarily expected to occur in 2012 and 2013; additional information regarding tax credit partnership investments is provided in Note 3. ProAssurance has also entered into agreements with several LPs/LLCs, totaling approximately $51 million at March 31, 2012, to be funded within the next five years as requested by the partnership.

 

24


Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

8. Long-term Debt

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

 

 

December 31, December 31,
     (In thousands)  
    

March 31

2012

    

December 31

2011

 
  

 

 

 

Trust Preferred Securities due 2034, unsecured. Bears interest at a variable rate of LIBOR plus 3.85%, adjusted quarterly, set at 4.4% at March 31, 2012.

   $ 22,992       $ 22,992   

Surplus Notes due May 2034, unsecured. Bears interest at a variable rate of LIBOR plus 3.85%, adjusted quarterly, set at 4.3% at March 31, 2012.

     12,000         12,000   

Note Payable due February 2019, carried at fair value, principal of $17.0 million at March 31, 2012 and $17.1 million at December 31, 2011. Secured by available-for-sale securities having a fair value at March 31, 2012 of approximately $29.8 million. Bears interest at a variable rate of LIBOR plus 0.7%. See information below regarding the associated interest rate swap.

     14,962         14,180   

Note Payable due February 2012. Note was repaid on due date.

     —           515   

Revolving Credit Agreement, expires in 2014, maximum outstanding borrowing of $150 million, interest rate set at the time funds are borrowed. No borrowings have occurred during the periods shown.

     —           —     
  

 

 

 
   $ 49,954       $ 49,687   
  

 

 

 

Interest Rate Swap

ProAssurance 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, ProAssurance 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 $4.4 million at March 31, 2012 and $4.7 million at December 31, 2011. The Swap liability is classified as a part of other liabilities.

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, 2011 Form 10-K.

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

9. Shareholders’ Equity

At March 31, 2012 and December 31, 2011, 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.

During 2011 the Board of Directors of ProAssurance instituted a cash dividend policy. ProAssurance declared a quarterly dividend of $0.25 per common share for the first quarter of 2012, totaling $7.7 million, to be paid in April 2012. Any decision to pay future cash dividends is subject to the Board’s final determination after a comprehensive review of financial performance, future expectations and other factors deemed relevant by the Board. The liability for unpaid dividends is included in Other Liabilities.

At March 31, 2012 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 did not repurchase any common shares during the three months ended March 31, 2012. ProAssurance repurchased approximately 252,000 common shares, having a total cost of $15.0 million, during the three months ended March 31, 2011, including approximately 6,900 forfeited employer match shares (cost basis of $0.4 million) reacquired due to the termination of the ProAssurance Corporation Stock Ownership Plan.

Share-based compensation expense is $2.1 million and $1.7 million for the three months ended March 31, 2012 and 2011, respectively. Related tax benefits are $0.7 million and $0.6 million for the three months ended March 31, 2012 and 2011, respectively.

ProAssurance awarded approximately 25,000 restricted share units and 100,000 (target) performance share units to employees in February 2012. The fair value of each unit awarded was estimated at $89.28, equal to the market value of a ProAssurance common share on the date of grant. All awards are charged to expense as an increase to equity over the service period (generally the vesting period) associated with the award. Restricted share units and performance share units vest in their entirety at the end of a three-year period following the grant date based on a continuous service requirement and, for performance share units, achievement of a performance objective. Partial vesting is permitted for retirees. A ProAssurance common share is issued for each unit once vesting requirements are met, except that units sufficient to satisfy required tax withholdings are paid in cash. The number of common shares issued for performance share units varies from 75% to 125% of base awards depending upon the degree to which stated performance objectives are achieved. ProAssurance issued approximately 17,000 and 50,000 common shares, respectively, to employees in February 2012 related to restricted share units and performance share units granted in 2009. Shares issued for performance share units were awarded at the maximum level (125%).

ProAssurance issued approximately 19,000 and 20,000 common shares to employees in February 2012 and February 2011, 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).

 

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Table of Contents

ProAssurance Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2012

 

9. Shareholders’ Equity (continued)

 

Other Comprehensive Income

For all periods presented, other comprehensive income is comprised of unrealized gains and losses, including non-credit impairment losses, arising during the period related to available-for-sale securities less reclassification adjustments for gains (losses) from available-for-sale securities recognized in current period net income (net of tax). Accumulated other comprehensive income is comprised entirely of unrealized gains and losses from available for sale securities, net of tax.

Reclassification adjustments related to available-for-sale securities for the three months ended March 31, 2012 and 2011 are as follows:

 

 

     Three Months Ended
March  31
 
(In thousands)    2012     2011  
  

 

 

 

Net realized investment gains (losses) included in the calculation of net income

   $ 2,094      $ 2,179   

Tax effect (at 35%)

     (733     (763
  

 

 

 

Net realized investment gains (losses) reclassified from other comprehensive income

   $ 1,361      $ 1,416   
  

 

 

 

10. Variable Interest Entities

ProAssurance holds passive interests in a number of LPs/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 of significance with any of the entities to provide other financial support to or on behalf of the entity. At March 31, 2012 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 LPs/LLCs formed for the purpose of achieving diversified equity and debt returns, and 2) a limited liability interest in a development stage business operation classified as Other Investments (carrying value of $31.6 million and $32.1 million at March 31, 2012 and December 31, 2011, respectively) and Investment in Unconsolidated Subsidiaries (carrying value of $24.6 million and $24.5 million at March 31, 2012 and December 31, 2011, respectively).

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-month periods ended March 31, 2012 and 2011.

 

27


Table of Contents

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 2011 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

The largest component of our liabilities is our reserve for losses and loss adjustment expenses (reserve for losses or reserve), and the largest component of expense for our operations is incurred losses and loss adjustment expenses (also referred to as “loss and loss adjustment expenses”, “incurred losses”, “losses incurred”, and “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 (MPL) claims, the trend of healthcare 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.

 

28


Table of Contents

Initial Reserve Estimates

In establishing our initial reserves for a given accident year, due to the lack of available data for both open and closed claims for that accident year, we rely heavily on the loss assumptions that are used in our pricing models. Loss assumptions used in our pricing models are based on our analysis of our actual and projected claims data, adjusted for perceived differences between the current legal and economic environment and that of the periods associated with the claims data. In recent years, our analysis of claims has indicated reductions in average loss costs, and we have reflected those reductions in our pricing loss assumptions. Our average pricing for 2012 is approximately 16 percentage points below our average pricing in 2006 (exclusive of our podiatry and chiropractic lines acquired in 2009), principally reflecting expected reductions in loss costs.

Historically, and at present, in establishing our initial reserves we utilize loss ratios that are approximately 8 to 10 percentage points above the loss ratios incorporated within the pricing targets for that accident year. We believe this reflects expected loss costs but also considers the 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) and produces a reasonable best estimate of the reserves required to cover actual ultimate unpaid losses. In the current environment this equates to an initial loss ratio of approximately 85% on our physician business as compared to an average loss ratio of approximately 75% assumed in our pricing.

The Effect of Changing Severity

Severity is defined as the average cost of resolving claims. The severity trend assumption (the expected annual percentage change in severity) is a key assumption for our pricing models. Our current pricing model assumes an average severity trend of 4%. If the severity trend were to be higher by 1 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 3 percentage points would result in a 10.1 percentage point increase in our expected loss ratio. Due to the long tailed nature of MPL claims and the previously discussed historical volatility of loss costs, selection of a severity trend assumption is a subjective process that is inherently likely to prove inaccurate over time. Given this long-tail and the previously discussed historical volatility of loss costs, we are generally judicious in making changes to our severity assumptions and actuarial estimations.

Recent changes in frequency have also complicated the selection of an appropriate severity trend. Both our internal and consulting actuaries have observed fluctuating but generally lower claims frequency that cannot be attributed to any single factor. We believe that much of the reduction in the number of claims is the result of a decline in the filing of frivolous lawsuits that have historically been dismissed or otherwise result in no payment of indemnity on the part of our insureds. With fewer frivolous claims being filed we expect that the claims that are filed have the potential for greater average losses, or greater severity. As a result, we cannot be certain as to the impact this decline will ultimately have on the average cost of claims. Based on a weighted average of payments, resolution of 85% of claims for a given accident year requires more than eight years (based on a weighted average of payments). Due to this long tail, it will be several years before we are able to determine if the decline in frequency has indeed resulted in a related increase in severity.

Additionally, given the length of time required for resolution of our claims, we are cautious in giving full credibility to claims data indicating emerging trends. Numerical data both within our own information and in the broader MPL marketplace may in the short term indicate development of a trend, whether positive or negative, that mitigates or reverses over the longer term as claims mature and additional data becomes available. Our current severity trend assumption gives recognition to both the indications from our recent claims data and the known volatility associated with the long tail claims environment in which we operate.

 

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Loss Development

We re-evaluate our previously established reserves each period based on our most recently available claims data and available industry trend information. Changes to previously established reserve estimates are recognized in the current period if management’s best estimate of ultimate losses differs from the estimate previously established. While management considers a variety of variables in determining its best estimate, in general, as claims age, our methodologies for estimating reserves give more weight to actual loss costs which, as a whole, continue to indicate that ultimate loss costs will be lower than our previous estimates. The development recognized in both the first quarter of 2012 and in the first quarter of 2011 is primarily attributable to the favorable resolution of claims during the period and an evaluation of established case reserves and paid claims data that indicates that the actual severity associated with the remaining claims will be lower than we had previously estimated. The Critical Accounting Estimates discussion in our 2011 Form 10K includes a more detailed discussion of the methodologies used to evaluate our reserves, beginning on page 30.

Reinsurance

We use insurance and reinsurance (collectively, “reinsurance”) to provide capacity to write larger limits of liability, to provide protection against losses in excess of policy limits, and to stabilize underwriting results in years in which higher losses occur. The purchase of reinsurance does not relieve us from the ultimate risk on our policies, but it does provide reimbursement for certain losses we pay.

We evaluate each of our ceded reinsurance contracts at inception to confirm that there is sufficient risk transfer to allow the contract to be accounted for as reinsurance under current accounting guidance. At March 31, 2012, all ceded contracts are accounted for as risk transferring contracts.

Our receivable from reinsurers on unpaid losses and loss adjustment expenses represents our estimate of the amount of our reserve for losses that will be recoverable under our reinsurance programs. We base our estimate of funds recoverable upon our expectation of ultimate losses and the portion of those losses that we estimate to be allocable to reinsurers based upon the terms of our reinsurance agreements. Our assessment of the collectability of the recorded amounts receivable from reinsurers considers the payment history of the reinsurer, publicly available financial and rating agency data, our interpretation of the underlying contracts and policies, and responses by reinsurers.

Given the uncertainty inherent in our estimates of losses and related amounts recoverable from reinsurers, these estimates may vary significantly from the ultimate outcome.

Under the terms of certain of our reinsurance agreements, the amount of premium that we cede to our reinsurers is based in part on the losses we recover under the agreements. Therefore we make an estimate of premiums ceded under these reinsurance agreements subject to certain maximums and minimums.

Any adjustments to our estimates of either balances recoverable under our reinsurance agreements or premiums owed under our agreements are reflected in then-current operations. Due to the size of our reinsurance balances, an adjustment to these estimates could have a material effect on our results of operations for the period in which the adjustment is made.

We make a determination of the amount of insurance risk we choose to retain based upon numerous factors including our risk tolerance and the capital we have to support it, the price and availability of reinsurance, volume of business, level of experience with a particular set of claims and our analysis of the potential underwriting results. We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. We utilize a reinsurance broker to assist us in the placement of our reinsurance program and in the analysis of the credit quality of our reinsurers. The determination of which reinsurers we choose to do business with is based upon an evaluation of the then-current financial strength, rating and stability of prospective reinsurers. However, the financial strength of our reinsurers, and their corresponding ability to pay us, may change in the future due to forces or events we cannot control or anticipate.

 

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We have not experienced significant collection difficulties due to the financial condition of any reinsurer as of March 31, 2012; however, periodically, reinsurers may dispute our claim for reimbursement from them based upon their interpretation of the terms of our agreements. We have established appropriate reserves for any balances that we believe may not be ultimately collected. Should future events lead us to believe that any reinsurer will not meet its obligations to us, adjustments to the amounts recoverable would be reflected in the results of current operations. Such an adjustment has the potential to be material to the results of operations in the period in which it is recorded; however, we would not expect such an adjustment to have a material effect on our capital position or our liquidity.

Investment Valuations

We record the majority of our investments at fair value as shown in the table below. The distribution of our investments based on GAAP fair value hierarchies (levels) is as follows:

 

     Distribution by
GAAP Fair Value Hierarchy
   

March 31, 2012

Total Investments

 
     Level 1     Level 2     Level 3    
  

 

 

 

Fair Value

     6     89     1     96

Investments not at fair value

           4
        

 

 

 

Total Investments

           100
        

 

 

 

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. All of our fixed maturity and equity security investments are carried at fair value. Our short-term securities are carried at amortized cost, which approximates fair value.

Because of the number of securities we own and the complexity and cost of developing accurate fair values, we utilize multiple independent pricing services to assist us in establishing the fair value of individual securities. The pricing services provide fair values based on exchange traded prices, if available. If an exchange traded price is not available, the pricing services, if possible, provide a fair value that is based on multiple broker/dealer quotes or that has been developed using pricing models. Pricing models vary by asset class and utilize currently available market data for securities comparable to ours to estimate the fair value for our security. The pricing services scrutinize market data for consistency with other relevant market information before including the data in the pricing models. The pricing services disclose the types of pricing models used and the inputs used for each asset class. Determining fair values using these pricing models requires the use of judgment to identify appropriate comparable securities and to choose a valuation methodology that is appropriate for the asset class and available data.

The pricing services provide a single value per instrument quoted. We review the values provided for reasonableness each quarter by comparing market yields generated by the supplied value versus market yields observed in the market place. In addition, we compare provided information for consistency with our other pricing services, known market data and information from our own trades, considering both values and valuation trends. We also compare yields indicated by the provided values to appropriate benchmark yields and review for values that are unchanged or that reflect an unanticipated variation as compared to prior period values. We also review weekly trades versus the prices supplied by our vendors. If a supplied value appears unreasonable, we discuss the valuation in question with the pricing service and will make adjustments if deemed necessary. To date, we have not adjusted any values supplied by the pricing services.

The pricing services do not provide a fair value unless an exchange traded price or multiple observable inputs are available. As a result, the pricing services may provide a fair value for a security in some periods but not others, depending upon the level of recent market activity for the security or comparable securities.

 

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Level 1 Investments

As of March 31, 2012, fair values for our equity and a portion of our short-term securities have been determined using an exchange traded price. There is little judgment involved when fair value is determined using an exchange traded price. In accordance with GAAP, for disclosure purposes we classify securities valued using an exchange traded price as Level 1 securities.

Level 2 Investments

With the exception of certain government bonds, most fixed income securities do not trade daily and thus exchange traded prices are generally not available for these securities. However, market information (often referred to as observable inputs or market data, including but not limited to, last reported trade, non-binding broker quotes, bids, benchmark yield curves, issuer spreads, two sided markets, benchmark securities, offers, and recent data regarding assumed prepayment speeds, cash flow and loan performance data) is available for most of our fixed income securities. We determine fair value for a large portion of our fixed income securities using available market information. In accordance with GAAP, for disclosure purposes we classify any securities that have been valued based on multiple market observable inputs as Level 2 securities.

Level 3 Investments

When a pricing service does not provide a value for one of our fixed maturity securities, management estimates fair value using either a single non-binding broker quote or pricing models that utilize market based assumptions which have limited observable inputs. The process involves significant judgment in selecting the appropriate data and modeling techniques to use in the valuation process. For disclosure purposes we classify fixed maturity securities that are valued using limited observable inputs as Level 3 securities.

We also classify as Level 3 our investment interests carried at fair value, based on NAVs provided to us. All investments valued in this manner are limited partnership (LP) and limited liability company (LLC) interests that hold debt and equity securities. Interests valued using a fund-provided NAV are as follows:

 

(In Millions)    Carrying Value  

Interests classified as a part of:

  

Other investments

   $ 15.7   

Investment in unconsolidated subsidiaries

     24.4   
  

 

 

 

Total interests valued using fund-provided NAV

   $ 40.1   
  

 

 

 

Investments Not at Fair Value

Investments having a carrying value of approximately $166.6 million, or 4% of total investments, are not carried at fair value, as required by GAAP for the type of investment. Refer to the following table and Note 2 of the Notes to Condensed Consolidated Financial Statements for further details:

 

(In Millions)    Carrying Value      GAAP Measurement
Method

Other investments:

     

Interests in LPs

   $ 15.9       Cost

Federal Home Loan Bank (FHLB) capital stock

     4.4       Cost

Other

     1.6       Cost
  

 

 

    

Total other investments

   $ 21.9      

Investment in unconsolidated subsidiaries:

     

Interests in tax credit partnerships

   $ 91.4       Equity

Interest in a business LLC

     0.2       Equity
  

 

 

    

Total investment in unconsolidated subsidiaries

   $ 91.6      

Business owned life insurance

   $ 53.1       Cash surrender value
  

 

 

    

Total investments not at fair value

   $ 166.6      
  

 

 

    

 

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Investment Impairments

We evaluate our investments on at least a quarterly basis for declines in fair value that represent OTTIs. In all instances we consider an impairment to be an OTTI if we intend to sell the security or if we believe we will be required to sell the security before we fully recover the amortized cost basis of the security. Otherwise, we consider various factors in our evaluation, depending upon the type of security, as discussed below.

For debt securities, we consider whether we expect to fully recover the amortized cost basis of the security, based upon consideration of some or all of the following:

 

   

third party research and credit rating reports;

 

   

the current credit standing of the issuer, including credit rating downgrades;

 

   

the extent to which the decline in fair value is attributable to credit risk specifically associated with an investment or its issuer;

 

   

our internal assessments and those of our external portfolio managers regarding specific circumstances surrounding an investment, which can cause us to believe the investment is more or less likely to recover its value than other investments with a similar structure;

 

   

for asset-backed securities, the origination date of the underlying loans, the remaining average life, the probability that credit performance of the underlying loans will deteriorate in the future, and our assessment of the quality of the collateral underlying the loan;

 

   

failure of the issuer of the security to make scheduled interest or principal payments;

 

   

any changes to the rating of the security by a rating agency;

 

   

recoveries or additional declines in fair value subsequent to the balance sheet date; and

 

   

our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value.

In assessing whether we expect to recover the cost basis of debt securities, particularly asset-backed securities, we must make a number of assumptions regarding the cash flows that we expect to receive from the security in future periods. These judgments are subjective in nature and may subsequently be proved to be inaccurate.

We evaluate our cost method interests in LPs/LLCs for OTTI by considering whether there has been a decline in fair value below the recorded value, which involves assumptions and estimates. We receive a report from each of the LPs/LLCs at least quarterly which provides us a NAV for our interest in the LP/LLC. The NAV is based on the fair values of securities held by the LP/LLC as determined by the LP/LLC manager. We consider the most recent NAV provided, the performance of the LP/LLC relative to the market, the stated objectives of the LP/LLC, the cash flows expected from the LP/LLC and audited financial statements of the entity, if available, in considering whether an OTTI exists.

Our investments in tax credit partnerships are evaluated for OTTI by comparing cash flow projections of the underlying projects generating the tax credits to our recorded basis, and considering our ability to utilize the tax credits generated by the investments.

We also evaluate our holdings of FHLB securities for impairment. We consider the current capital status of the FHLB, whether the FHLB is in compliance with regulatory minimum capital requirements, and the FHLB’s most recently reported operating results.

Deferred Policy Acquisition Costs

Policy acquisition costs (primarily commissions, premium taxes and underwriting salaries) which are directly related to the successful acquisition of new and renewal premiums are capitalized as deferred policy acquisition costs and charged to expense as the related premium revenue is recognized. We evaluate the recoverability of our deferred policy acquisition costs each reporting period, and any amounts estimated to be unrecoverable are charged to expense in the current period. Beginning January 1, 2012, in order to comply with adopted Financial Accounting Standards Board (FASB) guidance, we no longer capitalize internal selling agent and underwriter salary and benefit costs that are allocated to unsuccessful insurance contracts. Adoption of this guidance had no material effect on our results of operations or financial position.

 

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Deferred Taxes

Deferred federal income taxes arise from the recognition of temporary differences between the basis of assets and liabilities determined for financial reporting purposes and the basis determined for income tax purposes. Our temporary differences principally relate to loss reserves, unearned premiums, deferred policy acquisition costs, unrealized investment gains (losses) and investment impairments. Deferred tax assets and liabilities are measured using the enacted tax rates expected to be in effect when such benefits are realized. We review our deferred tax assets quarterly for impairment. If we determine that it is more likely than not that some or all of a deferred tax asset will not be realized, a valuation allowance is recorded to reduce the carrying value of the asset. In assessing the need for a valuation allowance, management is required to make certain judgments and assumptions about our future operations based on historical experience and information as of the measurement period regarding reversal of existing temporary differences, carryback capacity, future taxable income (including its capital and operating characteristics) and tax planning strategies.

Unrecognized Tax Benefits

We evaluate tax positions taken on tax returns and recognize positions in our financial statements when it is more likely than not that we will sustain the position upon resolution with a taxing authority. If recognized, the benefit is measured as the largest amount of benefit that has a greater than fifty percent probability of being realized. We review uncertain tax positions each period, considering changes in facts and circumstances, such as changes in tax law, interactions with taxing authorities and developments in case law, and make adjustments as we consider necessary. Adjustments to our unrecognized tax benefits may affect our income tax expense and settlement of uncertain tax positions may require the use of cash. At March 31, 2012, our current tax liability includes $23.7 million for unrecognized tax benefits, and $1.0 million for accrued interest related to unpaid taxes.

Goodwill

Management evaluates the carrying value of goodwill annually during the fourth quarter. If, at any time during the year, events occur or circumstances change that would more likely than not reduce the fair value below the carrying value, we also evaluate goodwill at that time. We evaluate goodwill as one reporting unit because we operate in a single operating segment and our segment components are economically similar. We estimate the fair value of our reporting unit on the evaluation date based on market capitalization and an expected premium that would be paid to acquire control of our Company (a control premium). We then perform a sensitivity analysis using a range of historical stock prices and control premiums. We concluded as of our last evaluation date, October 3, 2011, that the fair value of our reporting unit exceeded the carrying value and no adjustment to impair goodwill was necessary.

 

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Accounting Changes

We are not aware of any accounting changes that we have not yet adopted as of March 31, 2012 that would have a material impact on our results of operations or financial position. Note 1 of the Notes to Condensed Consolidated Financial Statements provides additional detail regarding accounting changes.

Liquidity and Capital Resources and Financial Condition

Overview

ProAssurance Corporation is a holding company and is a legal entity separate and distinct from its subsidiaries. Because the holding company has no other business operations, dividends from its operating subsidiaries represent a significant source of funds for its obligations, including debt service and dividends. At March 31, 2012, we held cash and liquid investments of approximately $329.2 million outside of our insurance subsidiaries that are available for use without regulatory approval. Our insurance subsidiaries, in aggregate, are permitted to pay dividends of approximately $275 million over the course of 2012 without the prior approval of state insurance regulators. However, the payment of any dividend requires prior notice to the insurance regulator in the state of domicile and the regulator may prevent the dividend if, in its judgment, payment of the dividend would have an adverse effect on the surplus of the insurance subsidiary. As of March 31, 2012, none of the permitted dividends have been paid.

Shareholder Dividends

During 2011 the Board of Directors of ProAssurance instituted a cash dividend policy. ProAssurance declared a quarterly dividend of $0.25 per common share for the first quarter of 2012, totaling $7.7 million, to be paid in April 2012. Any decision to pay future cash dividends is subject to the Board’s final determination after a comprehensive review of financial performance, future expectations and other factors deemed relevant by the Board. The liability for unpaid dividends is included in Other Liabilities.

Acquisitions

On November 30, 2010, we acquired 100% of the outstanding shares of American Physicians Service Group, Inc. (APS), a MPL provider principally insuring physicians in the state of Texas, in a transaction valued at $237 million including cash paid of $233 million and liabilities assumed of $4 million.

 

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Cash Flows

The principal components of our operating cash flows are the excess of premiums collected and net investment income over losses paid and operating costs, including income taxes. Timing delays exist between the collection of premiums and the payment of losses associated with the premiums. Premiums are generally collected within the twelve-month period after the policy is written while our claim payments are generally paid over a more extended period of time. Likewise, timing delays exist between the payment of claims and the collection of any associated reinsurance recoveries.

Our operating activities provided positive cash flows of approximately $28.1 million and $24.9 million for the three months ended March 31, 2012 and 2011, respectively. Operating cash flows for 2012 and 2011 compare as follows:

 

(In millions)    Cash  Flow
Increase
(Decrease)
 

Cash provided by operating activities three months ended March 31, 2011

   $ 25   

Increase (decrease) in operating cash flows for the three months ended March 31, 2012:

  

Increase in premium receipts (1)

     5   

Decrease in payments to reinsurers (2)

     11   

Increase in losses paid (3)

     (11

Increase in Federal and state income tax payments (4)

     (6

Other amounts not individually significant, net

     4   
  

 

 

 

Cash provided by operating activities three months ended March 31, 2012

   $ 28   
  

 

 

 

 

(1) The increase in premium receipts is primarily attributable to increased premium volume during the first three months of 2012.
(2) Reinsurance contracts are generally for premiums written in a specific annual period, but can remain in effect until all claims under the contract have been resolved. Some contracts require annual settlements while others require settlement only after a number of years have elapsed, thus the amounts paid can vary widely from period to period.
(3) The increase in paid losses reflects an increase in claims closed during 2012.
(4) The net increase in tax payments primarily reflects (in millions):

 

   

Estimated tax payments in 2012 were higher as compared to 2011 by $4.8 million.

   

Federal tax refunds received in 2011 of $7.1 million

   

Payments of $5.9 million made in 2011 for the 2008 and 2007 tax years as a result of federal tax return audits conducted by the Internal Revenue Service. The payments reduced tax liabilities recognized prior to January 1, 2011 and did not increase or decrease 2011 tax expense.

 

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Investment Exposures

The following table provides summarized information regarding our investments as of March 31, 2012:

 

            Unrealized Gains
(Losses) Included in
Carrying Value
                 
(In thousands)    Carrying
Value
     Gains      Losses    

Average

Rating 

  (1)    

% Total

Investments

 
  

 

 

 

Fixed Maturities

              

Government

              

U.S. Treasury

   $ 249,281       $ 15,094       $ (62   AA+     (2     6

U.S. Agency

     69,883         5,429         —        AA+     (2     2
  

 

 

       

Total government

     319,164         20,523         (62   AA+     (2     8

State and Municipal Bonds

     1,226,675         80,459         (619   AA       30

Corporate Debt

              

Financial institutions

     406,529         13,997         (1,847   A+       10

FDIC insured

     38,195         132         —        AA+     (2     1

Communications

     39,853         1,903         (124   BBB+       1

Utilities/Energy

     168,613         10,283         (587   A-       4

Industrial

     726,969         45,253         (1,209   A-       18

Transportation

     32,241         2,234         (44   A       1

Other

     17,201         945         —        A+       <1
  

 

 

       

Total corporate debt

     1,429,601         74,747         (3,811   A-       35

Asset-backed Securities

              

Agency mortgage-backed securities

     486,241         28,016         (119   AA+     (2     12

Non-agency mortgage-backed securities

     13,565         306         (535   BB       <1

Subprime

     8,088         331         (1,255   BBB       <1

Alt A

     5,136         48         (41   B-       <1

Commercial mortgage-backed securities

     77,819         5,554         (57   AAA       2

Credit card

     22,621         487         —        AAA       1

Automobile

     56,800         414         (6   AAA       1

Other

     17,176         296         (3   AAA       <1
  

 

 

       

Total asset-backed securities

     687,446         35,452         (2,016   AA+       17
  

 

 

       

Total fixed maturities

     3,662,886         211,181         (6,508   AA-       89

Equities

              

Equity

              

Financial

     33,423         22         —              1

Energy

     15,492         —           —              <1

Consumer oriented

     33,448         —           —              1

Technology

     8,825         —           —              <1

Industrial

     13,866         —           —              <1

All Other

     17,459         —           —              <1
  

 

 

       

Total equities

     122,513         22         —              3

Short-Term

     132,739         —           —              3

Business-owned life insurance (BOLI)

     53,115         —           —              1

Investment in Unconsolidated Subsidiaries

              

Investment in tax credit partnerships

     91,408         —           —              2

Business LLC interest

     182         —           —              <1

Investment in LPs primarily invested in:

              

Long/short equities

     17,505         —           —              <1

Non-public equities

     6,925         —           —              <1
  

 

 

       

Total investment in unconsolidated subsidiaries

     116,020         —           —              3

Other Investments

              

FHLB capital stock

     4,380         —           —              <1

Investments in LP/LLCs primarily invested in:

              

Private equity and debt

     15,742         —           —              <1

Long/short equities

     11,010         —           —              <1

Non-public portfolio

     4,854         —           —              <1

Other

     1,659         —           —              <1
  

 

 

       

Total other investments

     37,645         —           —              1
  

 

 

       

Total Investments

   $ 4,124,918       $ 211,203       $ (6,508         100
  

 

 

       

 

(1) A weighted average rating is calculated using available ratings from Standard & Poor’s, Moody’s and Fitch. The table presents the Standard & Poor’s rating that is equivalent to the computed average.
(2) The rating presented is the Standard & Poor’s rating rather than the average. The Moody’s rating is Aaa.

 

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A detailed listing of our investment holdings as of March 31, 2012 is presented in an Investor Supplement we make available in the Investor Relations section of our website, www.proassurance.com or directly at www.proassurance.com/investorrelations/supplemental.aspx.

We manage our investments to ensure that we will have sufficient liquidity to meet our obligations, taking into consideration the timing of cash flows from our investments, including interest payments, dividends and principal payments, as well as the expected cash flows to be generated by our operations. In addition to the interest and dividends we will receive, we anticipate that between $50 million and $90 million of our investments will mature (or be paid down) each quarter of the next year and become available, if needed, to meet our cash flow requirements. The primary outflow of cash at our insurance subsidiaries is related to paid losses and operating costs, including income taxes. The payment of individual claims cannot be predicted with certainty; therefore, we rely upon the history of paid claims in estimating the timing of future claims payments. To the extent that we may have an unanticipated shortfall in cash we may either liquidate securities or borrow funds under existing borrowing arrangements through our $150 million credit facility and the FHLB system. However, given the relatively short duration of our investments, we do not foresee any such shortfall. Additional information regarding the credit facility is detailed in Note 8 of the Notes to Condensed Consolidated Financial Statements.

Our investment portfolio continues to be primarily composed of high quality fixed income securities with approximately 96% of our fixed maturities being investment grade securities as determined by national rating agencies. The weighted average effective duration of our fixed maturity securities at March 31, 2012 is 4.1 years; the weighted average effective duration of our fixed maturity securities combined with our short-term securities is 3.9 years.

We increased our investment in tax credit limited partnerships by an additional $7 million during the first three months of 2012. These investments are comprised of multiple separate limited partner interests designed to generate investment returns by providing tax benefits to investors in the form of project operating losses and tax credits. The related properties are principally low income housing properties. The $91.4 million carrying value of the partnerships reflects the commitments to the partnerships (less amortization) of which approximately $43.8 million is not yet funded as of March 31, 2012.

European Debt Exposure

We have no direct European sovereign debt exposure. We have indirect exposure through our investments in debt securities and through our reinsurance receivables. Issuers of our debt securities and our reinsurers may hold European sovereign debt or have counterparty exposure to European banks or European corporations. Entities that have significant European exposure may suffer credit downgrades due to European sovereign debt exposure or due to European creditor exposure, if they have significant business in the Euro-zone or Eurocurrency denominated business should either or both fail, or should a severe European recession arise.

At March 31, 2012 we hold debt securities totaling $118.8 million (3% of our total investments) where the issuer is domiciled in Europe or the underlying revenue stream supporting the security is European. Of our European issuers, we believe those in the financial sector are most likely to suffer loss in the event of a European economic crisis.

Our investments outside of Europe, and particularly our financial sector investments, could also be negatively affected by a significant European economic crisis. Our financial sector investments outside of Europe approximate $393.3 million at March 31, 2012. Also, our reinsurers typically operate globally and have large investment portfolios which may be linked directly or indirectly to the European economy. As of December 31, 2011, two of our largest reinsurers were domiciled in Europe, with net receivables totaling approximately $61 million. Our reinsurance receivables total $256.1 million at March 31, 2012.

We do not currently write insurance policies in Europe and do not have any notes or accounts receivable from European issuers, exclusive of our reinsurance receivables.

 

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Reinsurance

We use reinsurance to provide capacity to write larger limits of liability, to provide protection against losses in excess of policy limits, and to stabilize underwriting results in years in which higher losses occur. The purchase of reinsurance does not relieve us from the ultimate risk on our policies, but it does provide reimbursement from the reinsurer for certain losses paid by us.

Our risk retention level is dependent upon numerous factors including our risk tolerance and the capital we have to support it, the price and availability of reinsurance, volume of business, level of experience with a particular set of claims and our analysis of the potential underwriting results. We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. We utilize a reinsurance broker to assist us in the placement of our reinsurance coverage and in the analysis of the credit quality of our reinsurers. We base our reinsurance buying decisions on an evaluation of the then-current financial strength, rating and stability of prospective reinsurers. However, the financial strength of our reinsurers, and their corresponding ability to pay us, may change in the future due to forces or events we cannot control or anticipate.

Taxes

During the fourth quarter of 2011 we received a Notice of Proposed Adjustment from the IRS related to its audit of our 2009 federal income tax return stating that the IRS intends to disallow a substantial portion of the loss and loss adjustment expense deduction taken on our 2009 return. The proposed adjustment represents a temporary timing difference and impacts the timing of deductions, rather than their allowance, and would shift tax from deferred to current tax expense but would not increase total tax expense. As now written, the Notice of Proposed Adjustment would require that we reduce our current deduction for loss and loss adjustment expenses, thereby increasing our current tax liability by approximately $100 million including interest associated with the timing of the payment. For financial reporting purposes, the tax liability asserted in the Notice of Proposed Adjustment would be offset, excluding the interest component, by the establishment of a deferred tax asset in recognition that these losses and loss adjustment expenses will be deductible in future periods. We believe that our loss and loss adjustment expense deduction was computed in a manner consistent with tax law, our past practices, and the practices of other MPL insurers. We remain in discussions with the IRS, challenging the position asserted in the Notice of Proposed Adjustment. There are other taxpayers with legal actions pending against the IRS in the United States Tax Court challenging IRS audit findings with regard to loss and loss adjustment expense deductions, and any rulings on these cases may influence the timing and amount of any asserted additional tax liability in any final report we receive from the IRS, and in our response to the final report. Any payments made would come out of our cash and investments and could impact future investment earnings, but, except for interest on past-due taxes if any, recorded tax expense will not change. We do not know when a final resolution will be reached with the IRS, or the amount of additional tax payments or interest that might be asserted.

 

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Debt

Our long-term debt as of March 31, 2012 is comprised of the following:

 

($ in thousands)    Contractual Rate      Outstanding Principal     

Carrying Value

March 31, 2012

 
  

 

 

 

Trust Preferred Securities due 2034

     4.4% (1)       $ 22,992       $ 22,992   

Surplus Notes due May 2034

     4.3% (1)         12,000         12,000   

Note Payable due February 2019 (2)

     6.6% (3)         17,027         14,962   

Revolving Credit Agreement (4)

     N/A                 —           —     
        

 

 

 
         $ 49,954   
        

 

 

 

 

(1) Adjusted quarterly based on LIBOR.
(2) The 2019 Note Payable is valued at fair value. See Note 8 of the Notes to Condensed Consolidated Financial Statements.
(3) A related interest rate swap fixes rate at 6.6%. Swap is settled monthly. See Note 8 of the Notes to Condensed Consolidated Financial Statements.
(4) No balance outstanding during 2012.

All of our long-term debt is currently repayable or redeemable, with proper notice, at a date no later than the next quarterly interest payment date. Insurance department approval is required for redemption of surplus notes.

During 2011, we entered into a revolving credit agreement that expires April 15, 2014. The agreement allows us to borrow up to $150 million that would be used for general corporate purposes, including, but not limited to, short-term working capital, share repurchases as authorized by the Board, and support for other activities we enter into in the normal course of business. To date, we have not borrowed any funds under the agreement. We are also a member of the FHLB. Through membership, we have access to cash advances which can be used for liquidity purposes or other operational needs. To date, we have not established a FHLB line of credit or materially utilized our membership.

ProAssurance is currently in compliance with all covenants associated with its borrowing arrangements. Additional information regarding our debt is provided in Note 8 of the Notes to Condensed Consolidated Financial Statements.

Treasury Shares

We did not repurchase any common shares during the three months ended March 31, 2012. At March 31, 2012, we have approximately $188.4 million in authorizations from our Board available for use for the repurchase of common shares or the retirement of outstanding debt.

Litigation

We are 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 ordinary course of business and, in accordance with GAAP for insurance entities, are considered as a part of our loss reserving process, which is described in detail under “Critical Accounting Estimates – Reserve for Losses and Loss Adjustment Expenses (reserve for losses or reserve).”

 

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Overview of Results–Three Months Ended March 31, 2012 and 2011

Net income and Operating income (a non-GAAP financial measure, see reconciliation below) are as follows:

 

    

Three Months Ended

March 31

 
  

 

 

 
(In millions, except per share data)    2012      2011  
  

 

 

 

Net income

   $ 55.6       $ 47.7   

Operating income

   $ 48.2       $ 45.0   

Net income per diluted share

   $ 1.80       $ 1.55   

Operating income per diluted share

   $ 1.56       $ 1.46   

Results from the three months ended March 31, 2012 and 2011 compare as follows:

Revenues

Net premiums earned increased for the 2012 three-month period by approximately $4.6 million or 3.5% primarily due to increased tail premiums written.

Our net investment result (which includes both net investment income and earnings from unconsolidated subsidiaries) decreased by $3.4 million or 9.7% for the 2012 three-month period. Net investment income decreased $2.7 million primarily due to lower yields on our fixed income securities. Our equity in earnings of unconsolidated subsidiaries decreased $0.7 million for the 2012 three-month period due to the amortization of a larger investment in tax credit partnerships.

Net realized investment gains are $10.7 million and $4.1 million for the 2012 and 2011 three-month periods, respectively. Results principally reflect an increase in trading portfolio gains of approximately $6.8 million for the 2012 three-month period due to an overall improvement in stock market yields.

Expenses

Current accident year net losses increased by $7.3 million or 6.6% for the 2012 three-month period, reflecting both changes in the mix of risks and higher loss expectations relative to certain risk exposures. We reduced net losses by $47.5 million for the 2012 three-month period and by $40.0 million for the same period in 2011 as a result of our review of our estimate of net losses incurred for prior accident years.

Underwriting, policy acquisition and operating expenses decreased by $1.3 million or 3.7% for the 2012 three-month period, primarily reflecting non-recurring costs incurred in 2011 related to the acquisition of APS and the termination of certain agency operations.

Ratios

Our net loss ratio decreased by 1.9 percentage points for the 2012 three-month period reflecting a 4.4 percentage point reduction attributable to prior year favorable development which was partially offset by an increase in the current accident year loss ratio of 2.5 percentage points reflecting both changes in the mix of risks and higher loss expectations relative to certain risk exposure.

Our underwriting expense ratio decreased 1.2 percentage points for the 2012 three-month period, reflecting lower expenses and a benefit from the growth in net earned premium.

Our operating ratio declined by 0.2 percentage points for the 2012 three-month period reflecting the improved net loss and expense ratios, offset by lower net investment income.

Return on equity is 10.2% for the 2012 three-month period on an annualized basis.

 

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Book Value per Share

Our book value per share at March 31, 2012 is $72.33 compared to $70.84 at December 31, 2011. The increase primarily reflects the effect of our 2012 income and an increase in accumulated other comprehensive income, partially offset by dividends declared during the period which reduced our book value per share by $0.25. Due to the size of our Shareholders’ Equity (approximately $2.2 billion at March 31, 2012), the growth rate of our book value per share may slow. The past growth rates of our book value per share do not necessarily predict similar future results.

Non-GAAP Financial Measures

Operating income is a non-GAAP financial measure that is widely used to evaluate the performance of insurance entities. Operating income excludes the after-tax effects of realized investment gains or losses, guaranty fund assessments and, in 2012, the effect of confidential settlements that do not reflect normal operating results. We believe operating income presents a useful view of the performance of our insurance operations, but should be considered in conjunction with net income computed in accordance with GAAP.

The following table is a reconciliation of Net income to Operating income:

 

    

Three Months Ended

March 31

 
  

 

 

 
(In thousands, except per share data)    2012     2011  
  

 

 

 

Net income

   $ 55,645      $ 47,693   

Items excluded in the calculation of operating income:

    

Net realized investment (gains) losses

     (10,677     (4,124

Guaranty fund assessments (recoupments)

     (23     (43

Effect of confidential settlements, net

     (714     —     
  

 

 

 

Pre-tax effect of exclusions

     (11,414     (4,167

Tax effect, at 35%

     3,995        1,458   
  

 

 

 

Operating income

   $ 48,226      $ 44,984   
  

 

 

 

Per diluted common share:

    

Net income

   $ 1.80      $ 1.55   

Effect of exclusions

     (0.24     (0.09
  

 

 

 

Operating income per diluted common share

   $ 1.56      $ 1.46   
  

 

 

 

 

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Results of Operations–Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011

Selected consolidated financial data for each period is summarized in the table below.

 

     Three Months Ended March 31  
  

 

 

 
($ in thousands, except share data)    2012     2011     Change  
  

 

 

 

Revenues:

      

Net premiums earned

   $ 136,659      $ 132,077      $ 4,582   

Net investment income

     33,492        36,161        (2,669

Equity in earnings (loss) of unconsolidated subsidiaries

     (2,066     (1,364     (702

Net realized investment gains (losses)

     10,677        4,124        6,553   

Other income

     1,809        2,587        (778
  

 

 

 

Total revenues

     180,571        173,585        6,986   
  

 

 

 

Expenses:

      

Losses and loss adjustment expenses

     78,305        77,101        1,204   

Reinsurance recoveries

     (8,106     (6,678     (1,428
  

 

 

 

Net losses and loss adjustment expenses

     70,199        70,423        (224

Underwriting, policy acquisition and operating expenses

     34,398        35,709        (1,311

Interest expense

     825        795        30   
  

 

 

 

Total expenses

     105,422        106,927        (1,505
  

 

 

 

Income before income taxes

     75,149        66,658        8,491   

Income taxes

     19,504        18,965        539   
  

 

 

 

Net income

   $ 55,645      $ 47,693      $ 7,952   
  

 

 

 

Earnings per share:

      

Basic

   $ 1.82      $ 1.56      $ 0.26   
  

 

 

 

Diluted

   $ 1.80      $ 1.55      $ 0.25   
  

 

 

 

Net loss ratio

     51.4     53.3     (1.9

Underwriting expense ratio

     24.7     25.9     (1.2
  

 

 

 

Combined ratio

     76.1     79.2     (3.1
  

 

 

 

Operating ratio

     51.6     51.8     (0.2
  

 

 

 

Tax ratio

     26.0     28.5     (2.5
  

 

 

 

Return on equity*

     10.2     10.2     0.0   
  

 

 

 

 

*Annualized

 

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Premiums Written

Changes in our premium volume are driven by four primary factors: (1) the amount of new business we generate, (2) the timing of premium written for business generated by multi-period policies, (3) our retention of existing business and (4) the premium charged for business that is renewed, which is affected both by rates charged and by the amount and type of coverage an insured chooses to purchase. The professional liability market remains competitive with some competitors choosing to compete primarily on price.

Gross, ceded and net premiums written are as follows:

 

     Three Months Ended March 31  
($ in thousands)    2012     2011     Change  
  

 

 

 

Gross premiums written

   $ 170,448      $ 160,813      $ 9,635        6.0

Ceded premiums written

     (12,450     (10,930     (1,520     13.9
  

 

 

   

Net premiums written

   $ 157,998      $ 149,883      $ 8,115        5.4
  

 

 

   

Gross Premiums Written

Gross premiums written by component are as follows:

 

     Three Months Ended March 31  
  

 

 

 
($ in thousands)    2012      2011      Change  
  

 

 

 

Gross premiums written:

          

Physician

   $ 132,023       $ 132,086       $ (63     0.0

Non-physician healthcare providers

     11,675         11,912         (237     (2.0 %) 

Hospital and facility

     7,076         6,249         827        13.2

Other

     6,100         5,307         793        14.9

Non-continuing

     377         465         (88     (18.9 %) 

Tail coverage premium, all policy types

     13,197         4,794         8,403        175.3
  

 

 

   

Total

   $ 170,448       $ 160,813       $ 9,635        6.0
  

 

 

   

Physician Premiums

Physician premiums for the three months ended March 31, 2012 remained relatively flat as compared to the same period of 2011 as the loss of business during the quarter was offset by endorsements made to existing policies and new business written in both the standard and excess and surplus lines markets.

Two-year term policies also contributed to the increase in gross premiums written. Gross premiums written associated with two-year term policies is $6.0 million and $5.5 million for the three months ended March 31, 2012 and 2011, respectively. We offer two-year term policies (as opposed to a one-year term) to our physician insureds in one selected jurisdiction. The premium associated with both years is included in written premium in the period the policy is written.

Our retention rate for our standard physician business is 92% and 90% for the three months ended March 31, 2012 and 2011, respectively. We calculate our retention rate as retained premium divided by all premium subject to renewal. Retention rates are affected by a number of factors. We may lose insureds to competitors or to self-insurance mechanisms (often when physicians join hospital-based practice groups) or due to pricing or other issues. We may choose not to renew an insured as a result of our underwriting evaluation. Insureds may also terminate coverage because they have left the practice of medicine for various reasons, principally for retirement but also due to disability or other personal reasons.

Charged rates for our renewed physician business remained flat as compared to the expiring premiums during 2011. Our charged rates include the effects of filed rates, surcharges and discounts. Despite competitive pressures, we continue to base our rates on expected losses, as indicated by our historical loss data and available industry loss data. We are committed to a rate structure that will allow us to fulfill our obligations to our insureds, while generating competitive returns for our shareholders.

 

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Non-physician Premiums

Our healthcare providers premiums remained relatively flat and are primarily comprised of dentists, chiropractors and allied health professionals.

Hospital and facility premiums increased for the first quarter of 2012 primarily due to new business.

Non-physician “other” premiums are primarily legal professional liability premiums. The increase in premium volume in 2012 principally relates to legal professional liability premiums.

Non-continuing premiums consist of premiums derived from optometry coverages discontinued in early 2012 and certain miscellaneous liability coverages which were discontinued in 2010 but that continued to produce small amounts of written premium in 2011.

Tail Coverage Premiums

We offer extended reporting endorsement or “tail” coverage to insureds that are discontinuing their claims-made coverage with us, and we also periodically offer “tail” coverage through custom policies. The amount of tail coverage premium written and earned can vary widely from period to period. A large portion of the 2012 increase in tail premium is attributable to a single custom policy issued to a hospital that terminated its self insurance arrangement.

Ceded Premiums Written and Ceded Premiums Ratio

Ceded premiums written compare as follows:

 

     Three Months Ended March 31  
  

 

 

 
($ in thousands)    2012     2011     Change  
  

 

 

 

Primary reinsurance arrangements

   $ 7,562      $ 6,697      $ 865         12.9

Other reinsurance

     4,888        4,233        655         15.5
  

 

 

    

Total ceded premiums written

   $ 12,450      $ 10,930      $ 1,520         13.9
  

 

 

    

Ceded premiums ratio*

     7.3     6.8     0.5      
  

 

 

    

 

* Ceded premiums written as a percentage of gross premiums written

We reinsure most of our MPL coverages under a single reinsurance agreement that is typically renewed annually in October. There was no significant change in treaty terms between 2012 and 2011. The 2012 increase associated with this reinsurance is largely due to higher premium volume relative to reinsured coverages.

The 2012 increase in Other reinsurance is largely attributable to policies written through our affiliation with Ascension Health (Ascension). Our arrangements with Ascension provide that a substantial portion of the initial policies written under the program are heavily reinsured by an Ascension affiliate. There was a nominal amount of Ascension premium written in the first quarter of 2011.

Net Premiums Earned

Net premiums earned are as follows:

 

     Three Months Ended March 31  
  

 

 

 
($ in thousands)    2012      2011      Change  
  

 

 

 

Premiums earned

   $ 147,602       $ 141,373       $ 6,229         4.4

Premiums ceded

     10,943         9,296         1,647         17.7
  

 

 

    

Net premiums earned

   $ 136,659       $ 132,077       $ 4,582         3.5
  

 

 

    

Net premiums earned consist of premiums earned less the portion of earned premiums that we cede to our reinsurers for their assumption of a portion of our losses. Because premiums are generally earned pro rata over the entire policy period, fluctuations in premiums earned tend to lag those of premiums written. Generally, our policies carry a term of one year, but as discussed above, we renew

 

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certain policies with a two-year term. Tail coverage premiums are generally 100% earned in the period written because the policies insure only incidents that occurred in prior periods and are not cancellable.

The 2012 increase in premiums earned is primarily attributable to tail premiums written in the first quarter of 2012. The 2012 increase in premiums ceded is primarily attributable to the previously discussed arrangements with Ascension.

Net Investment Income, Equity in Earnings (Loss) of Unconsolidated Subsidiaries, Net Realized Investment Gains (Losses)

Net Investment Income

Net investment income is primarily derived from the income earned by our fixed maturity securities and also includes income from our short-term and cash equivalent investments, dividend income from equity securities, earnings from other investments and increases in the cash surrender value of business owned life insurance contracts. Investment fees and expenses are deducted from investment income.

Net investment income by investment category is as follows:

 

     Three Months Ended March 31  
  

 

 

 
($ in thousands)    2012     2011     Change  
  

 

 

 

Fixed maturities

   $ 33,270      $ 35,951      $ (2,681     (7.5 %) 

Equities

     1,041        230        811        352.6

Short-term investments

     19        55        (36     (65.5 %) 

Other invested assets

     402        992        (590     (59.5 %) 

Business owned life insurance

     457        464        (7     (1.5 %) 

Investment expenses

     (1,697     (1,531     (166     10.8
  

 

 

   

Net investment income

   $ 33,492      $ 36,161      $ (2,669     (7.4 %) 
  

 

 

   

Fixed Maturities

The decrease in income for the 2012 three-month period primarily reflects lower yields on our portfolio, partially offset by higher average investment balances. A $0.4 million decline in the income produced by our Treasury Inflation-Protected Securities (TIPS) in 2012 contributed to the lower yield. In the first three months of 2011, our TIPS outperformed our other fixed maturities.

The overall yield on our portfolio declined for the 2012 three-month period because we were not able to reinvest proceeds from maturities, pay-downs and sales at rates comparable to expiring rates while maintaining our asset quality and the duration of our portfolio. Average yields for our available-for-sale fixed maturity securities during the three months ended March 31, 2012 and 2011 are as follows:

 

     Three Months Ended March 31
  

 

     2012    2011
  

 

Average income yield

   3.8%    4.1%

Average tax equivalent income yield

   4.4%    4.7%

The level of our investment in fixed maturity securities varies depending upon a number of factors, including, among others, our operating cash needs, anticipated shifts in credit markets, the attractiveness of other investment alternatives and cash needed for acquisitions or other capital purposes. In the first three months of 2012, as compared to 2011, our average investment in fixed maturities increased by approximately 1%.

 

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Equity in Earnings (Loss) of Unconsolidated Subsidiaries

Equity in earnings (loss) of unconsolidated subsidiaries is derived from our investment interests accounted for under the equity method, as follows:

 

    

Three Months Ended

March 31

 
  

 

 

 
(In thousands)    2012     2011     Change  
  

 

 

 

Investment LPs

   $ 590      $ 551      $ 39   

Business LLC interest

     (546     (818     272   

Tax credit partnerships

     (2,110     (1,097     (1,013
  

 

 

   

 

 

   

 

 

 

Equity in earnings (loss) of unconsolidated subsidiaries

   $ (2,066   $ (1,364   $ (702
  

 

 

   

 

 

   

 

 

 

We hold interests in certain LPs that derive earnings from trading portfolios. The performance of the LPs is affected by the volatility of equity and credit markets.

Our business LLC interest is a non-controlling interest in an entity that began active business in 2011. The entity is still in a start-up phase, and we recognized our portion of the LLC’s operating losses in 2012 and 2011. The carrying amount of our investment is currently $0.2 million.

Our tax credit investments are designed to generate investment returns by providing tax benefits to fund investors in the form of project operating losses and tax credits. Our tax credit partnerships reduced our tax expenses by approximately $2.6 million during the three months ended March 31, 2012, while we recognized $2.1 million of pre-tax amortization ($1.4 million after tax) on these investments noted in the table above.

Non-GAAP Financial Measure – Tax Equivalent Investment Result

We believe that to fully understand our investment returns it is important to consider the current tax benefits associated with certain investments; therefore, we impute a pro forma tax-equivalent investment result by adjusting the current tax benefit into the amount of investment income a taxable investment would need to produce to fairly compare to an investment with preferential tax treatment. We believe this better reflects the economics of our decision to invest in certain asset classes that are either taxed at lower rates and/or result in reductions to our current federal income tax expense.

 

     Three Months Ended March 31  
  

 

 

 
(In thousands)    2012     2011  
  

 

 

 

Net investment income, as reported for GAAP

   $ 33,492      $ 36,161   

Taxable equivalent adjustments, calculated using the 35% federal statutory tax rate

    

State and municipal bonds

     4,684        5,006   

BOLI

     246        250   

Dividends received deduction

     267        74   
  

 

 

 

Pro forma tax-equivalent net investment income

     38,689        41,491   

Equity in earnings (loss) of unconsolidated subsidiaries, as reported for GAAP

     (2,066     (1,364

Taxable equivalent adjustment, calculated using the 35% federal statutory tax rate

    

Tax credit partnerships

     4,043        2,029   
  

 

 

 

Pro forma tax-equivalent equity in earnings (loss) of unconsolidated subsidiaries

     1,977        665   
  

 

 

 

Pro forma tax-equivalent investment results

   $ 40,666      $ 42,156   
  

 

 

 

 

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Net Realized Investment Gains (Losses)

The following table provides detailed information regarding our net realized investment gains (losses).

 

    

Three Months Ended

March 31

 
  

 

 

 
(In thousands)    2012     2011  
  

 

 

 

Total other-than-temporary impairment losses:

    

Residential mortgage-backed securities

   $ (245   $ (450

Corporate debt

     (830     —     

Other investments

     (131     (1,387

Portion recognized in (reclassified from) Other comprehensive income:

    

Residential mortgage-backed securities

     —          (568
  

 

 

 

Net impairment losses recognized in earnings

     (1,206     (2,405

Gross realized gains, available-for-sale securities

     3,887        4,628   

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

     (94     (244

Net realized gains (losses), trading securities

     777        2,692   

Change in unrealized holding gains (losses), trading securities

     7,937        (771