| AMERICAN PHYSICIANS SERVICE GROUP INC Item 1A Risk Factors 10 ITEM 1A RISK FACTORS An investment in our common stock involves certain risks |
| Below are the most significant factors that make an investment in us speculative or risky |
| You should consider carefully these risks together with all of the other information included in this Form 10-K and the documents that we have incorporated by reference |
| APPROXIMATELY ONE-HALF OF OUR REVENUE FROM CONTINUING OPERATIONS IS ATTRIBUTABLE TO OUR MANAGEMENT AGREEMENT WITH APIE, PURSUANT TO WHICH WE RECEIVE FEES BASED ON APIE &apos S SUCCESS AND ARE REQUIRED TO PROVIDE CERTAIN SERVICES AT OUR COST Substantially all of our revenue from the insurance services segment, representing 46prca of total revenue in 2005, was attributable to FMI providing management services to APIE As the attorney-in-fact for APIE, FMI receives a percentage of the earned premiums of APIE, as well as a portion of APIEapstas profits |
| Accordingly, any reduction in premiums written by APIE or profit recorded by APIE would have a proportional negative effect on our revenues and net income |
| The amount of these premiums can be adversely affected by competition |
| Substantial underwriting losses, which might result in a curtailment or cessation of operations by APIE, would also adversely affect FMIapstas revenue and, accordingly, our revenue |
| The loss or reduction of these management fees could have a material adverse effect on our business, financial condition and results of operations |
| Pursuant to our management agreement with APIE, FMI is required to perform a number of sales, underwriting and management and administrative services at the direction of the Board of APIE associated with the issuance of insurance policies for APIE to earn FMIapstas management fee, regardless of the cost to FMI of providing those services |
| We could lose money or be less profitable if our cost of providing those services increases significantly |
| OUR SUBSIDIARIES OPERATE IN HIGHLY COMPETITIVE BUSINESSES AGAINST COMPETITORS WITH GREATER FINANCIAL, MARKETING, TECHNOLOGICAL, PERSONNEL AND OTHER RESOURCES The industries in which we operate are highly competitive |
| Many of our competitors possess greater financial, marketing, technological and other resources |
| There can be no assurance that we will be able to continue to compete successfully |
| APS Financial, Asset Management and APS Clearing are engaged in a highly competitive business |
| Their competitors include, with respect to one or more aspects of their business, all of the member organizations of the New York Stock Exchange and other registered securities exchanges, all members of the NASD, registered investment advisors, members of the various commodity exchanges and commercial banks and thrift institutions |
| In many instances APS Financial is competing directly with these organizations |
| In addition, there is competition for investment funds from the real estate, insurance, banking and thrift industries |
| As stated above, substantially all of our revenue from the insurance services segment was attributable to FMI providing management services to APIE Because FMIapstas management fee is based on the earned premiums of APIE and APIEapstas profits, our revenue can be adversely affected by APIEapstas competition |
| APIE competes with several insurance carriers, including Medical Protective Insurance Company, Texas Medical Liability Trust, ProAssurance, The Doctors Company, Advocate MD and the Texas Medical Liability Insurance Underwriting Association (JUA), which is the state-sponsored insurer of last resort |
| APIE does not have the capacity to write the volume of business equal to that of the other major carriers |
| With the successful passing of tort reform in late 2003, there is an increased likelihood of additional companies re-entering the Texas market |
| 10 AS A HOLDING COMPANY, OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS ARE DEPENDENT ON OUR SUBSIDIARIES We are principally a holding company with assets consisting primarily of cash and investment securities |
| Consequently, our ability to pay our operating expenses and to service our indebtedness is dependent upon the earnings of our subsidiaries and our ability to receive funds from such subsidiaries through loans, dividends or otherwise |
| The subsidiaries are legally distinct entities and have no obligation, contingent or otherwise, to make funds available to us for such obligations |
| In addition, our subsidiaries &apos ability to make such payments is subject to applicable state laws, and claims of our subsidiaries &apos creditors will generally have priority as to the assets of such subsidiaries |
| Accordingly, there can be no assurance that our subsidiaries will be able to pay funds to us or that such funds, if any, received by us will be sufficient to enable us to meet our obligations |
| OUR FINANCIAL SERVICES BUSINESS IS SUBJECT TO EXTENSIVE GOVERNMENT REGULATION The securities industry is subject to extensive governmental supervision, regulation and control by the SEC, state securities commissions and self-regulatory organizations, which may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of APS Financial or any of its officers or employees |
| The NASD regulates our financial services business &apos marketing activities |
| The NASD can impose certain penalties for violations of its advertising regulations, including censures or fines, suspension of all advertising, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer or any of its officers or employees |
| Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of a system to ensure compliance with these laws and rules, as well as our ability to attract and retain qualified compliance personnel |
| We could be subject to disciplinary or other actions due to claimed noncompliance in the future, which could have a material adverse effect on our business, financial condition and operating results |
| There can be no assurance that the federal or state governments or self-regulatory organizations having jurisdiction over our insurance and securities brokerage businesses will not adopt regulations or take other actions, such as the failure to renew or the revocation of required licenses and certifications, that would have a material adverse effect on our business, financial condition and results of operations |
| In addition, our operations and profitability may be affected by additional legislation, changes in rules promulgated by the SEC, NASD, the Board of Governors of the Federal Reserve System, the various stock exchanges and other self-regulatory organizations, and state securities commissions, or changes in the interpretation or enforcement of existing laws or rules |
| WE ARE RELIANT ON KEY EXECUTIVES, KEY PERSONNEL AND KEY ACCOUNTS We believe that our success depends on the efforts and abilities of a relatively small group of executive personnel |
| The loss of services of one or more of these key executives could have a material adverse effect on our business |
| We do not maintain key man life insurance on any of our key executives |
| We have entered into an employment agreement with Kenneth S Shifrin, our Chairman of the Board and Chief Executive Officer, that expires on April 1, 2007 |
| Additionally, although we have been fortunate in retaining our key salespersons for many years, a loss of one or more key salespersons and/or a loss of one or more key accounts is possible and could have a material adverse effect upon earnings |
| WE ARE EXPOSED TO INTEREST RATE RISK Our exposure to market risk for changes in interest rates relates to both our investment portfolio and our revenues generated through commissions at our financial services segment |
| All of our marketable fixed income securities are designated as available for sale and, accordingly, are presented at fair value on our balance sheets |
| Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates |
| 11 Changes in interest rates could have an impact at our broker/dealer subsidiary, APS Financial |
| The general level of interest rates may trend higher or lower in 2006, and this move may impact our level of business in different fixed-income sectors |
| If a generally improving economy is the impetus behind higher rates, then while our investment grade business may drop off, our high-yield business might improve with improving credit conditions |
| A volatile interest rate environment in 2006 could also impact our business as this type of market condition can lead to investor uncertainty and their corresponding willingness to commit funds |
| As we currently have no debt and do not anticipate the need to take on any debt in 2006, interest rate changes will have no impact on our financial position as it pertains to interest expense |
| WE ARE EXPOSED TO INVESTMENT RISK As of December 31, 2005, our recorded basis in debt and equity securities was approximately dlra18dtta3 million |
| A material other than temporary decline in the value of any of these investments could have a material adverse effect on our financial condition and results of operations |
| We regularly review the carrying value of our investments and identify and record losses when events and circumstances indicate that such declines in the fair value of such assets below our accounting basis are other than temporary |
| During 2004, the value of one of our investments, FIC, had declined significantly |
| In October 2004, we determined that this decline in market price should be considered "e other than temporary "e as defined in Statements of Financial Accounting Standards (SFAS) Nodtta 115, Accounting for Certain Investments in Debt and Equity Securities, as amended |
| Consequently, we recorded pre-tax charges to earnings totaling dlra2cmam567cmam000 in 2004 |
| These charges reduced our cost basis in FIC from dlra5cmam647cmam000, or dlra14dtta67 per share, to dlra3cmam080cmam000, or dlra8dtta00 per share which was equal to the quoted market price of FIC shares on December 31, 2004 |
| During 2005, we took additional pre-tax charges to earnings totaling dlra135cmam000, further reducing our cost basis in FIC to dlra2cmam945cmam000, or dlra7dtta65 per share |
| While we currently continue to have the ability and the intent to hold the stock indefinitely, we concluded that the additional uncertainty created by FICapstas late filings, together with the lack of its current financial information, dictated that the 2004 and 2005 declines should be viewed as other than temporary |
| In July, 2005 FIC was able to file its 2003 Form 10-K but has yet to file any 2004 or 2005 Forms 10-Q or 10-K and thus continues to be de-listed on the NASDAQ Stock Market |
| We also have an investment of 143cmam000 shares of common stock of HealthTronics, Inc |
| Although we have an unrealized gain of approximately dlra376cmam000 as of December 31, 2005, this investment can also be at risk should market or economic conditions change for the worse or should adverse situations occur at HealthTronics, such as a major product line becoming obsolete |
| The remainder of our corporate equity and fixed income investments share the same risks as HealthTronics but our exposure is much lower |
| FAILURE OF THIRD-PARTY VENDORS TO PROVIDE CRITICAL SERVICES COULD HARM OUR BUSINESS We rely on a number of third parties to assist in the processing of our transactions, including online and Internet service providers, back office processing organizations, and market makers |
| While we have selected these third-party vendors carefully, we do not control their actions |
| Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could have a material adverse effect on our business, financial condition and operating results |
| WE ARE SUBJECT TO MARKET FORCES BEYOND OUR CONTROL WHICH COULD IMPACT US MORE SEVERELY THAN OUR COMPETITORS Our securities brokerage business, like other securities firms, is directly affected by economic and political conditions, broad trends in business and finance and changes in volume and price levels of securities transactions |
| In 12 recent years, the US securities markets have experienced significant volatility |
| If our trading volume decreases, our revenues decline |
| Also, when trading volume is low, our profitability is adversely affected because our overhead remains relatively fixed, despite lower compensation costs associated with commission revenues |
| Severe market fluctuations in the future could have a material adverse effect on our business, financial condition and operating results |
| Although we have diversified our product and service revenue streams, some of our competitors with more diverse product and service offerings might withstand such a downturn in the securities industry better than we would |
| OUR CUSTOMERS MAY DEFAULT ON THEIR MARGIN ACCOUNTS, EFFECTIVELY PASSING THEIR LOSSES ON TO US Our securities brokerage customers sometimes purchase securities on margin through our clearing organization; therefore we are subject to risks inherent in extending credit |
| This risk is especially great when the market is rapidly declining |
| In such a decline, the value of the collateral securing the margin loans could fall below the amount of a customerapstas indebtedness |
| Specific regulatory guidelines mandate the amount that can be loaned against various security types |
| APS Financial rigorously adheres to these guidelines and in a number of instances exceeds those requirements |
| Independent of our review, our corresponding clearing organization independently maintains a credit review of our customer accounts |
| If customers fail to honor their commitments, the clearing organization would sell the securities held as collateral |
| Any such losses could have a material adverse effect on our business, financial condition and operating results |
| APS FINANCIAL MUST MAINTAIN CERTAIN NET CAPITAL REQUIREMENTS THAT COULD SLOW OUR EXPANSION PLANS OR PREVENT PAYMENTS OF DIVIDENDS The SEC, NASD and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers |
| Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets |
| If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the SEC and suspension or expulsion by the NASD, and could ultimately lead to the firmapstas liquidation |
| If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require the intensive use of capital would be limited |
| Such operations may include trading activities and the financing of customer account balances |
| Also, our ability to pay dividends, repay debt and redeem or purchase shares of our outstanding stock could be severely restricted |
| A significant operating loss or an extraordinary charge against net capital could adversely affect the ability of APS Financial to expand or even maintain its present levels of business, which could have a material adverse effect on our business, financial condition and operating results |
| OUR TRADING SYSTEMS MAY FAIL, RESULTING IN SERVICE INTERRUPTIONS Our securities brokerage business receives and processes trade orders through internal trading software and touch-tone telephones and depends heavily on the integrity of the electronic systems supporting this type of trading |
| Heavy stress placed on our systems during peak trading times could cause our systems to operate too slowly or fail |
| If our systems or any other systems in the trading process slow down significantly or fail even for a short time, our customers would suffer delays in trading, potentially causing substantial losses and possibly subjecting us to claims for such losses or to litigation claiming fraud or negligence |
| During a systems failure, we may be able to take orders by telephone; however, only associates with securities brokerapstas licenses can accept telephone orders, and an adequate number of associates may not be available to take customer calls in the event of a systems failure |
| In addition, a hardware or software failure, power or telecommunications interruption or natural disaster could cause a system failure |
| Any systems failure that interrupts our operations could have a material adverse effect on our business, financial condition and operating results |
| 13 OUR REVENUES AND OPERATING PERFORMANCE MAY FLUCTUATE WITH INSURANCE BUSINESS CYCLES Growth in premiums written in the medical professional liability industry have fluctuated significantly over the past 10 years as a result of, among other factors, changing premium rates |
| The cyclical pattern of such fluctuation has been generally consistent with similar patterns for the broader property and casualty insurance industry, due in part to the participation in the medical professional liability industry of insurers and reinsurers which also participate in many other lines of property and casualty insurance and reinsurance |
| Historically, the financial performance of the property and casualty insurance industry has tended to fluctuate in cyclical patterns characterized by periods of greater competition in pricing and underwriting terms and conditions, a soft insurance market, followed by period of capital shortage, lesser competition and increasing premium rates, a hard insurance market |
| For several years in the 1990s, the medical professional liability industry faced a soft insurance market that generally resulted in lower premium rates |
| The medical professional liability industry is currently in a hard insurance market cycle |
| We cannot predict whether, or the extent to which, the recent increase in premium rates will continue |
| BECAUSE OUR BOARD OF DIRECTORS MUST BALANCE FIDUCIARY OBLIGATIONS TO APIE AND TO OUR SHAREHOLDERS, OUR BOARD OF DIRECTORS MAY MAKE DECISIONS THAT ARE NOT SOLELY IN THE INTERESTS OF OUR SHAREHOLDERS As attorney-in-fact, FMI is contractually required to provide management and administrative services to APIE In such capacity, FMI also has a fiduciary duty to the policyholders of APIE to protect their interests |
| Likewise, we have a fiduciary duty to our shareholders |
| Certain issues arise that may create conflicts of interest between these fiduciary duties |
| Among such potential conflicts of interest are: o Management must devote attention to the business interests of both APIE and us; o APIE may enter into other transactions and contractual relationships with us and our subsidiaries; and o State regulators could challenge the reasonableness of the transactions between us and APIE because of potential or actual conflicts of interest |
| As a consequence, our board of directors may make decisions or take actions that are not solely in the interests of our shareholders, although we believe that decisions that strengthen APIE could have a long-term positive effect on us |
| If, for example, there should be a need to strengthen the surplus of APIE, our board of directors may decide to reduce the management fee rate and/or that a capital contribution should be made by us to APIE in the form of a surplus note or some other form |
| Under such circumstances, we may be required to provide such capital to APIE at a lower rate of return than would be available with other investments or at no return at all |
| Payments of interest and repayment of principal on a surplus note are subject to prior approval of the Texas Department of Insurance, which may not approve such payments |
| We may also find it necessary to fund additional surplus for APIE by issuing additional shares of our capital stock, resulting in dilution of existing shareholders &apos interest |
| IF MARKET CONDITIONS CAUSE REINSURANCE TO BE MORE COSTLY OR UNAVAILABLE FOR APIE, OUR MANAGEMENT FEE MAY BE REDUCED As part of APIEapstas overall risk management strategy, it purchases reinsurance for amounts of risk from dlra250cmam000 up to dlra1cmam000cmam000 |
| If APIE is unable to maintain its current reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates, or if APIE is unable to renew its expiring reinsurance coverage or to obtain new reinsurance coverage, APIE may be adversely affected by losses or have to reduce the amount of risk it underwrites, in either case reducing our management fee |