Medical Mutual Insurance Company of North Carolina Raleigh, NC

Report on Examination As of December 31, 2005

STATE North Carolina

ZONE Southeastern

Medical Mutual Insurance Company of North Carolina Report on Examination Table of Contents

Report on Examination of Financial Condition .............................................................................................. 1 Scope of the Examination............................................................................................................................... 3 History of the Company.................................................................................................................................. 3 Management and Control ............................................................................................................................... 4 Board of Directors ...................................................................................................................................... 4 Directors ..................................................................................................................................................... 4 Committees................................................................................................................................................. 4 Officers ....................................................................................................................................................... 5 Members ..................................................................................................................................................... 5 Corporate Records.......................................................................................................................................... 5 Fidelity Bond and Other Insurance ................................................................................................................. 6 Accounts and Records .................................................................................................................................... 6 Benefit Plans................................................................................................................................................... 6 Territory and Plan of Operation...................................................................................................................... 6 Growth of the Company ................................................................................................................................. 7 Statutory Statement of Admitted Assets ......................................................................................................... 8 Statutory Statement of Liabilities, Capital and Surplus .................................................................................. 9 Statutory Statement of Operations ................................................................................................................ 10 Statutory Statement of Capital and Surplus .................................................................................................. 11 Statutory Statement of Cash Flow ................................................................................................................ 12 Notes to the Statutory Financial Statement................................................................................................... 13 1. Analysis of Examination Adjustments ............................................................................................... 13 2. Comments, Recommendations and Directives................................................................................... 13 3. Basis of Presentation and Summary of Significant Accounting Policies ........................................... 14 4. Analysis of Assets.............................................................................................................................. 15 5. Reinsurance........................................................................................................................................ 16 6. Reserves............................................................................................................................................. 18 7. Transactions with Affiliates ............................................................................................................... 19 8. Capital and Surplus............................................................................................................................ 20 9. Contingencies and Commitments....................................................................................................... 20 10. Leases ................................................................................................................................................ 21 11. Subsequent Events ............................................................................................................................. 21 Appendix A – Organization Chart ................................................................................................................ 23 Appendix B – Report Distribution................................................................................................................ 24

Medical Mutual Insurance Company of North Carolina Report on Examination of Financial Condition Honorable James E. Long Commissioner of Insurance State of North Carolina Raleigh, North Carolina

Honorable Alfred W. Gross, Chairman Financial Condition (EX4) Subcommittee National Association of Insurance Commissioners 120 West 12th Street, Suite 1100 Kansas City, Missouri 64105-192

Honorable Eleanor Kitzman Secretary, Southeastern Zone South Carolina Department of Insurance PO Box 100105 Columbia, South Carolina 29202-3105

Sir or Madam: Pursuant to your instructions and in accordance with Section 58-2-131 of the General Statutes of North Carolina (“GS”), the North Carolina Department of Insurance (“Department”) conducted an examination of the financial condition of Medical Mutual Insurance Company of North Carolina (“Company”) as of December 31, 2005, including any material transactions and events occurring subsequent to the examination date and noted during the course of this examination. The Department’s most recent prior examination of the Company was as of December 31, 2000. The Department conducted this examination under the association plan of the National Association of Insurance Commissioners (“NAIC”). This examination was made in accordance with auditing standards established by the Department and procedures established by the NAIC and, accordingly, included a review of the Company’s practices and procedures, an examination of management records, tests and analyses of detailed transactions, and an evaluation of assets and a determination of liabilities as of December 31, 2005, and other auditing procedures considered necessary under the circumstances. Items considered to be of significance are included in this report on examination; however, the following area reviewed during the course of this examination disclosed no material adverse findings and, as such, is not included in this report: business in force by states.

The accompanying financial statement properly presents the Company’s statutory financial position as of December 31, 2005, and statutory results of operations for the period then ended. The supporting exhibits properly present the information required to be included, in conformity with reporting practices prescribed by the GS. The financial statement and supporting schedules as of December 31, 2004, are unexamined and are presented for comparative purposes only. We conclude that the Company complies with the minimum capital and surplus requirements of GS 58-7-75 for the kinds of insurance that the Company has been authorized to write. The requirements pursuant to that statute are a combined minimum surplus of $1,000,000.

Respectfully submitted, ____________________________________ Robert F. Stanfield, CPA, CFE Chief Examiner North Carolina Department of Insurance November 15, 2007

STATE OF NORTH CAROLINA COUNTY OF WAKE I, Stephen W. Johnson, Assistant Chief Examiner, North Carolina Department of Insurance, being first, duly sworn, deposes and says that this report on examination, subscribed by him, is true and correct to the best of his knowledge and belief.

Signature:

Date: ______________________

Stephen W. Johnson

Sworn and subscribed before me this _____day of _______________________, 2007. Notary Public Signature:_______________________________ Notary Public Seal:

2

Medical Mutual Insurance Company of North Carolina Report on Examination December 31, 2005 and 2004 Scope of the Examination The North Carolina Department of Insurance (“Department”) conducted an examination of the financial condition of Medical Mutual Insurance Company of North Carolina (“Company”) as of December 31, 2005, including any material transactions and events occurring subsequent to the examination date and noted during the course of this examination. The examination covered the period from January 1, 2001, to December 31, 2005. The Department conducted this examination under the association plan of the National Association of Insurance Commissioners (“NAIC”). Examiners from the State of North Carolina, representing the Southeastern Zone, participated in this examination. This examination was made in accordance with auditing standards established by the Department and procedures established by the NAIC and, accordingly, included a review of the Company’s practices and procedures, an examination of management and corporate records, tests and analyses of detailed transactions, and an evaluation of assets and a determination of the existence of liabilities as of December 31, 2005. In addition, our examination included tests to provide reasonable assurance that the Company was in compliance with applicable laws and regulations. In planning and conducting our examination, we gave consideration to the concepts of materiality and risk, and our examination efforts were directed accordingly. The Company was audited annually by an independent public accounting firm. The firm expressed unqualified opinions on the Company’s financial statements for calendar years 2001 through 2005. We placed substantial reliance on the audited statements for calendar years 2001 through 2004, and consequently, performed only minimal testing for those periods. We concentrated our efforts on the year ended December 31, 2005. We reviewed the working papers prepared by the independent public accounting firm related to the audit for the year ended December 31, 2005, and utilized, wherever possible, work performed by the firm to supplement our own audit procedures during our examination of the Company. History of the Company The Company was incorporated on October 3, 1975, under the laws of the State of North Carolina as a mutual casualty insurance company. The Company commenced business on October 23, 1975, with a guaranty fund of $832,600, which enabled the Company to issue policies without contingent liability. The Company sold and redeemed guaranty capital certificates from inception until 1991. The Company did not sell any guaranty capital certificates from 1991 to December 19, 2002. The Company reinstituted a membership requirement that each physician insured in North Carolina must own guaranty capital issued by the Company, effective December 20, 2002. The minimum investment required is $2,000 and the maximum investment allowed is $5,000. The Company is authorized to issue up to $25.0 million of guaranty capital. The Company had $11.8 million of guaranty capital certificates outstanding as of December 31, 2005. The Company issued a $10.0 million surplus note to I-Preferred Term Securities III, Ltd., on October 16, 2003. The surplus note has a 30-year maturity and interest at London Inter Bank Offered Rate (“LIBOR”), plus 3.95%. The Company has the right to redeem the note, in whole or in part, after October 29, 2008. The amount of gross paid in and contributed surplus remained unchanged at $25,900 during the period under examination.

3

Medical Mutual Insurance Company of North Carolina Report on Examination December 31, 2005 and 2004

Management and Control Board of Directors The business of the Company is managed by its management team and subject to review by the Board of Directors (“Board”) consisting of at least seven, but not more than eighteen members divided into three classes, with the terms of one class expiring each year. A majority of the Board constitutes a quorum for the transaction of business. Directors Directors are elected by the membership and guaranty capital owners of record annually and hold office for one, two, or three years until the expiration of the term of office of the class of directors. The guaranty capital owners are entitled to elect no more than one-half of the total number of directors, that total number consisting of one-half of the members of each class of directors. The following individuals were serving as directors at December 31, 2005: Name

Address

Henry David Bruton, MD Henry James Carr, Jr., MD

Raleigh, North Carolina Raleigh, North Carolina

Charles Carlos Crowell, MD Allen Dale Jenkins

High Point, North Carolina Raleigh, North Carolina

Thomas Hatton McCoy, MD

Charlotte, North Carolina

Victoria Carla Donato Neave, MD Rachel Hereford Ross, MD

High Point, North Carolina Salisbury, North Carolina

Robert Edmund Schaaf, MD

Raleigh, North Carolina

Chris Michael Teigland, MD

Charlotte, North Carolina

Principal Business Affiliation Secretary of the Company President and Chairman of the Board of the Company President of Crowell Heart, PA Chief Executive Officer of the Company First Vice President and Vice Chairman of the Board of the Company, Senior Physician at OrthoCarolina, PA Johnson Neurological Clinic President of Rowan Regional Pathology Associates, PA Chief Executive Officer and Managing Partner of Wake Radiology Services Carolinas Medical Center

Committees The Board has the authority to constitute an executive committee and that the chairman of the Board and president, the vice chairman of the Board and first vice president, and three at-large members shall be appointed. The committee has all the powers of the Board to manage the business and conduct the affairs of the Company in the interim between meetings of the Board, except that the executive committee does not have the power to fill vacancies in its own membership or in the Board. The Board may also establish other committees with duties prescribed by the Board.

4

Medical Mutual Insurance Company of North Carolina Report on Examination December 31, 2005 and 2004

Officers The bylaws provide that the Board will elect the officers of the Company. The officers of the Company consist of a chairman of the board and president, vice-chairman of the board and first vice-president, secretary, treasurer, chief executive officer, and other such officers deemed necessary by the Board. All officers shall hold offices for one year or until their successors are elected and qualified. The chairman of the board and president, and vice chairman of the board and first vice president, and secretary shall be current or former members of the corporation, but no such qualifications shall be required of the other officers of the corporation. Any two or more offices may be held by the same person except the offices of the chairman of the board and president and secretary. The following individuals were serving as officers at December 31, 2005. Name Henry James Carr, Jr., MD Paul Mark Davidson, CPA Henry David Bruton, MD Allen Dale Jenkins Thomas Hatton McCoy, MD David Paul Sousa Brian Kent Tucker

Title President Treasurer Secretary Chief Executive Officer First Vice President Senior Vice President and General Counsel Senior Vice President

Members The bylaws provide that only health care providers and health care professionals lawfully engaged in the health care profession are eligible for membership. Each guaranty capital owner is entitled to one vote for each $100 invested, or as otherwise provided by the law. Each member or guaranty capital owner of record is to be notified of all meetings of the Company. An annual meeting of the members is held each year on a date and time determined by the Board, and at a place designated in the notice of the meeting. A majority of the membership entitled to vote, represented in person or by proxy, constitutes a quorum for any meeting of the membership. Special meetings may be called by order of the chairman of the board and president, whenever requested in writing by 10% or more of the members, or the majority of the directors. Corporate Records We reviewed the minutes of the meetings of the board of directors and committees for the period under examination. Based on our review, the minutes documented the Company’s significant transactions and events, and that the directors approved these transactions and events.

5

Medical Mutual Insurance Company of North Carolina Report on Examination December 31, 2005 and 2004

Fidelity Bond and Other Insurance The Company had fidelity bond coverage in the amount of $1.0 million. The amount of coverage complies with the coverage amounts recommended by the NAIC for the Company. In addition, the Company had other insurable risks (e.g., business, property, liability, etc.) Based on our review, the Company’s insurance coverage for these risks appeared to be adequate. Accounts and Records The Company’s general accounting records consisted of an automated general ledger and various automated subsidiary ledgers and manual subsidiary records. Benefit Plans Employees of the Company are covered under a qualified defined contribution retirement plan sponsored by the Company. The Company’s contribution for the retirement plan totaled $495,111 and $507,798 in 2005 and 2004, respectively. The Company provides a 401(k) plan to which the Company makes limited matching contributions of compensation contributed by the employee. The Company’s contribution for the 401(k) plan totaled $135,188 and $118,244 in 2005 and 2004, respectively. The Company offers a deferred compensation plan to its directors and officers. Directors may defer up to 100% of their compensation, and officers may defer portions of their compensation. The Company also provides an additional compensation program to the Treasurer; Chief Executive Officer; Senior Vice President; and Senior Vice President and General Counsel; (“executive officers”) through numerous real estate investments. Refer to Notes 2a, 7, 9 and 11 for additional information concerning these programs. Territory and Plan of Operation At December 31, 2005, the Company was licensed in the states of Alabama, Arkansas, Florida, Georgia, Kentucky, Mississippi, North Carolina, South Carolina, Tennessee, and Virginia. Statutory deposits are maintained as required by insurance regulatory agencies for doing business in such jurisdictions. The Company’s 2005 Annual Statement Schedule E Part 3 contains a complete description and listing, by State, of the Company’s statutory deposits. The Company writes medical professional liability insurance on a direct basis and through independent agents for the distribution of its product and solicitation of business. All policies are issued annually. Insureds may elect to pay on an installment basis.

6

Medical Mutual Insurance Company of North Carolina Report on Examination December 31, 2005 and 2004

Growth of the Company The following statistics, obtained from Annual Statements filed with the Department and from reports on examination, illustrate the growth of the Company for the five (5) year period ended December 31, 2005. (In Thousands of $’s)

Year 2005 2004 2003 2002 2001

Admitted Assets 321,508 272,328 236,405 194,999 169,726

Liabilities 224,689 196,194 169,891 152,953 134,423

Surplus Notes & Guaranty Capital 21,832 21,562 21,391 8,757 1,824

Gross Paid In & Contributed Surplus 26 26 26 26 26

Unassigned Funds 74,961 54,546 45,097 33,263 33,453

(In Thousands of $’s)

Year 2005 2004 2003 2002 2001

Premiums Earned 80,268 72,040 55,572 48,061 36,651

Losses and LAE Incurred 58,246 62,285 48,281 43,771 34,954

7

Other Underwriting Expenses 7,250 7,699 6,525 4,313 4,887

Net Underwriting Gains or (Losses) 14,772 2,056 766 (23) (3,190)

Medical Mutual Insurance Company of North Carolina Statutory Statement of Admitted Assets (In Thousands)

December 31, 2004 2005 (unexamined)

Admitted Assets $

191,602

163,187

Common stocks

31,368

31,854

Preferred stock

10,317

11,065

Cash and short-term investments

33,318

18,269

7,066

7,873

273,671

232,248

Bonds

Other invested assets Total cash and invested assets Investment income due and accrued Premiums and agents'balances booked but deferred and not yet due Reinsurance recoverable

2,235

1,886

39,010

32,636

855

673

Current federal income tax recoverable and interest thereon

412 5,368

4,182

Electronic data processing equipment

244

291

Other

125

Net deferred tax asset

Total admitted assets

$

See accompanying notes to statutory financial statement

8

321,508

272,328

Medical Mutual Insurance Company of North Carolina Statutory Statement of Liabilities, Capital and Surplus (In Thousands)

December 31, 2004 2005 (unexamined)

Liabilities $

Losses Loss adjustment expenses Other expenses payable Taxes, licenses and fees

76,832

76,592

60,629

53,086

1,390

1,762

542

531

Federal tax liability

4,478

Unearned premiums

46,935

36,639

Funds held by Company under reinsurance contracts

29,382

25,280

Amounts withheld or retained by Company for account of others Other Total liabilities

6,962

5,981

(2,461)

(3,677)

224,689

196,194

21,832

21,562

26

26

74,961

54,546

96,819

76,134

321,508

272,328

Capital and Surplus Surplus notes Gross paid in and contributed surplus Unassigned funds Total capital and surplus Total liabilities, capital and surplus

$

See accompanying notes to statutory financial statement

9

Medical Mutual Insurance Company of North Carolina Statutory Statement of Operations (In Thousands)

Year Ended December 31, 2004 2005 (unexam ined)

Underwriting Income $

80,268

72,040

Losses incurred

27,026

31,343

Loss expenses incurred

31,220

30,942

Premiums earned

7,250

7,699

Total underwriting deductions

65,496

69,984

Net underwriting gain

14,772

2,056

Net investment income earned

6,900

5,731

Net realized capital gains

1,026

1,689

Net investment gain

7,926

7,420

4,954

554

4,954

554

9,016

3,199

18,636

6,831

Other underwriting expenses incurred

Investment Income

Other Income(Loss) Other miscellaneous income Total other income Federal income tax incurred $

Net income

See accompanying notes to statutory financial statement

10

Medical Mutual Insurance Company of North Carolina Statutory Statement of Capital and Surplus (In Thousands)

December 31, 2004 2005 (unexam ined)

$

Capital and surplus, beginning of year

76,134

66,514

18,636

6,831

836

2,195

Capital and surplus increases (decreases): Net income Change in net unrealized capital gains/(losses) Change in deferred income tax

2,114

798

Change in non-admitted assets

(1,171)

(431)

270

Change in surplus notes Change in provision for reinsurance

171 56

Change in surplus as regards policyholders for the year $

Capital and surplus, end of year

See accompanying notes to statutory financial statement

11

20,685

9,620

96,819

76,134

Medical Mutual Insurance Company Statutory Statement of Cash Flow (In Thousands)

Year ended December 31, 2004 2005 Cash From/(Used by) Operations

(unexamined)

84,244

73,669

Net investment income

$

7,004

6,468

Miscellaneous income

4,955

554

Premiums collected net of reinsurance

96,203

80,691

Benefit and loss related payments

25,787

22,094

Commissions, expenses paid and aggregate write-ins for deductions

30,636

29,008

5,673

3,667

62,096

54,769

34,107

25,922

Totals

Federal income taxes paid net of tax on capital gains Totals Net cash from operations Cash From/(Used by) Investments Proceeds from investments sold, matured or repaid

101,216

72,206

Cost of investments acquired

124,720

107,056

Net cash from/(used by) investments

(23,504)

(34,850)

270

171

Other cash provided

4,176

63

Net cash from financing and miscellaneous sources

4,446

234

15,049

(8,694)

18,269 33,318

26,963 18,269

Cash From/(Used by) Financing and Miscellaneous Sources Surplus notes

Reconciliation of Cash and Short-Term Investments Net change in cash and short-term investments Cash and short-term investments, beginning of year Cash and short-term investments, end of year

$

See accompanying notes to statutory financial statement

12

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

1.

Analysis of Examination Adjustments December 31, 2005 Net Net Income

Surplus

(In Thousands)

$

As orginally reported to the Department a.) Losses a.) Loss adjustment expenses a.) Federal tax liability Adjusted surplus and net income

$

91,219

13,036

7,200

7,200

800

800

(2,400) 96,819

(2,400) 18,636

a) The reserve for losses and the reserve for loss adjustment expenses was reduced by $7.2 million and $0.8 million, respectively due to a redundancy of reserves. In addition, the federal tax liability was increased by $2.4 million. 2.

Comments, Recommendations and Directives a.) The Company entered into five real estate investments through nine limited liability companies (“LLCs”) beginning in 1997 and continuing through 2007. The Company states that these LLCs were created specifically in order to provide additional compensation to the Chief Executive Officer; Senior Vice President; Senior Vice President and General Counsel; and Treasurer (“executive officers”) and for investing in real estate. The Company provided capital contributions, capital contribution commitments, and guaranteed lines of credit to the LLCs. The Company also provided guaranteed loan commitments and guaranteed lines of credit to affiliates of the LLCs. The executive officers received ownership in the LLCs with combined percentages ranging from 24% to 94.8%. Combined capital contributions made by the executive officers to the LLCs range from $240 to $6,860. Investments by the Company made directly or indirectly to the LLCs and affiliates of the LLCs range from $550,000 to $2,587,750 except for one LLC, to which the Company provided guarantees of $535,000. The Company’s direct or indirect ownership percentages of the LLCs range from 2.34% to 60%. Minutes reflecting full Board of Director or Executive Committee approval vary in their degree of specificity. GS 58-7-200(c) states that “No insurer shall directly or indirectly invest in, or lend its funds to, any of its directors, officers…or any other person in which an officer, director…is substantially interested, nor shall any director, officer…directly or indirectly accept the funds.” GS 58-7-200(d) further states that “No director, officer…shall…be monetarily interested either as principal, corporation, agent, or beneficiary, in any such purchase, sale, or loan; and no financial obligation of any such director, officer… shall be guaranteed by the insurer.” In addition, the Company entered into the above guarantees without providing prior notice to the Commissioner of its intentions at least 30 days before these transactions, pursuant to GS 58-1930(b)(4). The Department communicated to the Company violations of GS58-19-30 and 58-7-200. Company has agreed to unwind the executive compensation transactions to the extent possible.

13

The

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

The Department directed the Company to cease any further activities involving the establishment of such LLCs and any further activity within the existing LLC investments, which involve either the provision of guarantees by the Company or any executive officer interest. b.) The Company entered into an investment management agreement with First Citizens Bank in 2005. The Company did not file the agreement with the Commissioner on or before the effective date pursuant to GS 58-34-10(a). The Company subsequently filed the agreement after the Department directed the Company to do so. The Company is directed to comply with the above referenced statute and to ensure that the disclosure requirements of GS 58-34-10(b) and (d) are met in the future. c.) The Company failed to file valuation information for a private placement security with the NAIC Securities Valuation Office (“SVO”) as required in Part Six, Section 3(d) of the Purposes and Procedures Manual of the NAIC SVO. The Company subsequently submitted the filing after the Department directed the Company to do so. The Company is directed to ensure that such filings are made in the future. 3.

Basis of Presentation and Summary of Significant Accounting Policies The accompanying financial statement has been prepared in conformity with the accounting practices prescribed by the GS. The more significant accounting policies followed by the Company are as follows: Bonds: Carried at amortized cost. Preferred stocks: Where permitted are carried at cost, all others are carried at values provided by the NAIC Securities Valuation Office. Common stocks: Carried at market value except stocks of subsidiaries that are valued using the equity method. Investment in Subsidiary: The Company owns 100% of the outstanding shares of Medical Security. The Company accounts for this investment using the equity method of accounting. Changes in the Company’s net equity investment in Medical Security are charged or credited directly to surplus. Dividends received are accounted for as investment income. Cash and short-term investments: Carried at amortized cost (which approximates fair value) and includes money market instruments and debt securities with maturities of less than one year. Premiums: Earned over the policy period and reduced for reinsurance ceded. The reserve for unearned premium is determined on a monthly pro rata basis.

14

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

Reinsurance: Premiums, commissions, expense reimbursements, and reserves are accounted on a basis consistent with the original policies issued and the terms of the reinsurance agreements. Premiums ceded are reported as a reduction of premium income. Losses and loss adjustment expenses are reported as reductions of those items. Uncollateralized exposures from unauthorized reinsurers are deducted directly from capital and surplus through a provision for unauthorized reinsurance. Changes to the provision for unauthorized reinsurance are credited or charged directly to surplus. 4.

Analysis of Assets The following represents an analysis of the Company’s net admitted assets: December 31, 2005 (In Thousands)

Assets not Admitted

Assets Bonds

$

Net Admitted Assets

191,602

191,602

Preferred stocks

10,317

10,317

Common stocks

31,368

31,368

Cash and short-term investments

33,318

33,318

7,066

7,066

Other invested assets Total cash and invested assets Premiums and agents'balances in course of collection

273,671 39,010

Reinsurance recoverable

-

855

273,671 39,010 855

Net deferred tax asset

9,968

Investment income due and accrued

2,235

2,235

Electronic data processing equipment and software

244

244

Furniture and equipment

513

513

390 326,886

265 5,378

Other assets Total admitted assets

$

15

4,600

5,368

125 321,508

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

5.

Reinsurance The Company has excess of loss reinsurance contracts to limit its exposure to losses. Reinsurance contracts do not relieve the Company of its primary obligation to policyholders. Failure of the reinsurers to discharge their obligations could result in losses to the Company. The Company utilizes John B. Collins Associates, Inc. as a reinsurance intermediary to negotiate and obtain reinsurance contracts on its behalf for specifically identified risks. Direct and assumed, and ceded premiums written and earned are as follows: December 31, 2004 2005

(In Thousands)

(unexamined)

$

Direct and assumed written Ceded written Net written Direct and assumed earned Ceded earned Net earned

$

133,027

114,497

42,463 90,564

35,608 78,889

121,413

106,621

41,145 80,268

34,581 72,040

The reinsurers share in the risks at different levels as specified in the reinsurance contracts. The types of contracts, retention limits, and insurance coverage are described below. Reinsurance Ceded Excess of Loss Coverage Primary Excess of Loss The Company has a primary excess of loss agreement with various reinsurers effective January 1, 2005. The reinsurers provide $500,000 coverage of ultimate net loss in excess of the $500,000 Company’s retention per insured on claims made policies covering physicians’ and surgeons’ professional liability, nonphysician professional liability, and directors’ and officers’ liability. The reinsurers also provide $800,000 of coverage in excess of the $200,000 company’s retention per insured on claims made policies covering dentists’ professional liability and designated contractual liability. In addition, the Company retains the first $1.0 million of ultimate net loss arising out of each event or in the aggregate from any one insured, and the reinsurers’ liability will not exceed $2.0 million per event or in the aggregate from any one insured. The Company ceded written premiums totaling $19.8 million and $17.0 million in 2005 and 2004, respectively, under this contract.

16

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

First Excess of Loss The Company has a first excess of loss agreement with various reinsurers effective January 1, 2005. The reinsurers provide $1.0 million coverage of ultimate net loss in excess of the $1.0 million Company’s retention per insured on claims made policies covering physicians’ and surgeons’ professional liability, dentists’ (including dental hygienists’) professional liability, and non-physician professional liability. In addition, the Company retains the first $3.0 million of ultimate net loss in the aggregate from any one insured, and the reinsurers’ liability will not exceed $1.0 million in the aggregate from any one insured The Company ceded written premiums totaling $13.8 million and $12.2 million in 2005 and 2004, respectively, under this contract. Second Excess of Loss The Company has a second excess of loss agreement with various reinsurers effective January 1, 2005. The reinsurers provide up to $4.0 million coverage of ultimate net loss in excess of the $2.0 million Company’s retention per insured on claims made policies covering physicians’ and surgeons’ professional liability, dentists’ (including dental hygienists’) professional liability, and non-physician professional liability. In addition, the Company retains the first $4.0 million of ultimate net loss in the aggregate from any one insured, and the reinsurers’ liability will not exceed $4.0 million in the aggregate from any one insured The Company ceded written premiums totaling $5.9 million and $5.3 million in 2005 and 2004, respectively, under this contract. Third Excess of Loss The Company has a third excess of loss agreement with various reinsurers effective January 1, 2005. The reinsures provide up to $4.0 million coverage of ultimate net loss in excess of the $6.0 million company’s retention per insured on claims made under policies covering physicians’ and surgeons’ professional liability, dentists’ (including dental hygienists’) professional liability, and non-physician professional liability. In addition, the Company retains the first $8.0 million of ultimate net loss in the aggregate from any one insured, and the reinsurers’ liability will not exceed $4.0 million in the aggregate from any one insured The Company ceded written premiums totaling $2.8 million and $962,583 in 2005 and 2004, respectively, under this contract. Med-Defense/Tax Audit The Company has a certificate of reinsurance with certain underwriters, effective January 1, 2005. Coverage is provided for up to $20,000 per event and in the aggregate per insured for expenses incurred in a disciplinary proceeding, an Internal Revenue Service audit, or other insured event under the Med-Defense coverage of a policy. The Company pays 10% of any legal expense in excess of the $250 per insured event and in the aggregate per insured deductible. The Company ceded net written premiums totaling $145,250 and $145,250 in 2005 and 2004, respectively, under this certificate of reinsurance.

17

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

Reinsurance Assumed The Company has an Excess of Loss agreement with its subsidiary, Medical Security Insurance Company (“MSIC”), effective January 1, 2001. The Company assumes 100% of the ultimate net loss in excess of $200,000 for policies covering dentists’ (including dental hygienists’) professional liability, and 100% of the ultimate net loss for policies covering physicians’ and surgeons’ professional liability written by MSIC. In 2005 and 2004, the Company assumed premiums of approximately $792,975 and $689,904, respectively, under this contract. The Company retrocedes all dental business in excess of $200,000, and all physician business in excess of $500,000 under its excess of loss agreements. 6.

Reserves The following provides a reconciliation of the Company’s reserves for losses and loss adjustment expenses, net of reinsurance recoverables. December 31, 2005 2004

(In Thousands)

(unexamined)

126,000

108,800

Add: Provision for losses and loss adjustment expenses, current year Change in estimated losses and loss adjustment expenses, prior years

61,426 (3,180)

58,030 4,255

Total incurred

58,246

62,285

Deduct: Losses and loss adjustment expenses paid/(recovered), current year Losses and loss adjustment expenses paid, prior years

5,516 43,730

4,688 40,397

Total paid

49,246

45,085

135,000

126,000

9,000

17,200

Reserve for losses and loss adjustment expenses, beginning of year

$

Reserve for losses and loss adjustment expenses, end of year Increase in reserve for losses and loss adjustment expenses

$

Reserves for losses and loss adjustment expenses are reported net of the amounts that are recoverable under the Company’s reinsurance contracts. At December 31, 2005 and 2004, the liability for losses and loss adjustment expenses was reduced by $82.7 million and $69.2 million, respectively, for amounts to be recovered from reinsurers.

18

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

7.

Transactions with Affiliates a.

The Company has management agreements with each of its three subsidiaries to provide general management, underwriting, marketing, claims administration, financial management and information technology services. During 2005, the Company received management fees of $688,647 from MSIC, and $348,000 from MMIC Agency, Inc., (“Agency”) respectively. During 2004, management fees received totaled $652,202 from MSIC, $348,000 from Agency and $240,000 from Canopy Systems Inc., (“Canopy”), respectively. The management agreement with Canopy terminated January 7, 2005, when the Company sold their investment in this non-insurance subsidiary.

b.

The Company is included in a consolidated federal income tax return in accordance with a tax sharing agreement with its affiliates, effective January 1, 1996. Affiliates included in the 2005 return were MSIC, Agency, Canopy, and MMIC RPG, Inc. The provision for federal income tax is computed as if the Company were filing a separate income tax return. Benefits, which arise from tax credits and net operating losses, are allocated to the Company producing such results to the extent they are utilized in the consolidated income tax provision. Intercompany tax balances are settled on an annual basis within 60 days of year-end.

c.

The Company paid commissions of $455,751 and $537,785 for business written by the Agency during 2005 and 2004, respectively.

d.

The Company made capital contributions of $0 and $2.6 million to MMIC Rex Partners, LLC in 2005 and 2004, respectively.

e.

The Company made capital contributions of $20,500 and $1.3 million to MMIC Trinity Road Partners, LLC in 2005 and 2004, respectively.

f.

The Company made capital contributions of $0 and $523,000 to Canopy, and $0 and $52 to Spring Commons Partners, LLC, in 2005 and 2004, respectively.

g.

The Company received dividends of $333,500 and $382,000 from MSIC, $84,353 and $0 from MMIC Lake Partners, LLC, in 2005 and 2004, respectively

h.

The Company leased office space from Lake Partners, LLC (See Note 9) during 2005 and 2004.

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Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

8.

Capital and Surplus The following, in conjunction with the Statutory Statement of Surplus (see page 11), represents the changes in the Company’s capital and surplus since the Department’s last examination.

(In Thousands)

Capital and surplus, beginning of year

$

Capital and surplus increases/(decreases): Net income Net unrealized capital gains/(losses) Change in nonadmitted assets Change in net deferred income taxes Change in provision for reinsurance Cumulative effect of changes in accounting principles Net change in guaranty capital certificates Change in surplus notes Prior period adjustments Changes in surplus as regards policyholder for the year

December 31, 2002

2001

(unexamined)

(unexamined)

(unexamined)

42,046

35,303

36,561

4,794 7,047 415 (366) (56)

4,004 (976) (1,552) 2,655

3,494 (7,234) (1,805) 2,129

6,933

2,203 (45)

24,468

(4,321) 6,743

(1,258)

66,514

42,046

35,303

2,634 10,000

Capital and surplus, end of the year

9.

2003

$

Contingencies and Commitments The Company purchased annuities payable to the claimant for which the Company remains contingently liable. Annuities with life insurers that exceed 1% of capital and surplus as of December 31, 2005, are as follows: 2005 $5,001,555

Metropolitan Life Insurance Company

The Company has an ownership interest in its home office building through MMIC Lake Partners LLC, a 60% owned subsidiary. The Company has a capital contribution commitment of $250,000, payable in the event of default on a loan related to the Company’s home office building through Lake Partners Indemnitor, LLC. The Company is a member of Lake Partners Indemnitor, LLC. The Company guaranteed a $6.2 million construction loan commitment and a $522,749 line of credit issued to MMIC-TL Inc. Partners, LLC, an affiliate of MMIC Trinity Road Partners, LLC (“Trinity Road”), of which $3.0 million and $0 was outstanding as of December 31, 2005 and 2004, respectively. Trinity Road is a 60% owned subsidiary of the Company. The Company has right of contribution from other members, totaling 25%, for their proportionate share in the event of default.

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Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

The Company guaranteed a $2.0 million line of credit issued to its affiliate Spring Commons Partners LLC, of which $1.1 million and $0 was outstanding as of December 31, 2005 and 2004, respectively. The Company guaranteed a $4.6 million construction loan commitment issued to Arena Place Development, LLC, an affiliate of Spring Commons Partners LLC, of which $1.2 million had been repaid, and $1.3 million was outstanding as of December 31, 2005. Medical Mutual has a right of contribution from the other members, totaling 55%, for their proportionate share in the event of default. The Company is subject to guaranty fund and other assessments by the states in which it writes business to cover losses to policyholders of insolvent or rehabilitated insurance companies. Expenses incurred for guaranty fund assessments were $15,315 and $18,071 in 2005 and 2004, respectively. 10. Leases The Company leases office space and equipment under operating lease agreements that expire through 2013. Rent expense for all leases was $559,618 and $561,228 for 2005 and 2004, respectively. Future lease commitments under the agreement are as follows: Year

Amount

(in thousands)

2006 2007 2008 2009 2010 2011 and thereafter

$ 667 675 685 701 716 1,861

Total

$5,305

11. Subsequent Events In the first quarter of 2006, the Company sold A4 Health Systems to Allscripts Healthcare Solutions, Inc., a publicly traded company. As a result of the transaction, the Company realized a capital gain of $5.1 million. During 2006, the Company formed ALA Commercial, LLC, where MMIC is the sole member and manager to facilitate investment in real estate in Apex, NC. The Company transferred its ownership of ALA Commercial, LLC; MMIC Lake Partners, LLC; MMIC Rex Partners, LLC; and MMIC Trinity Road Partners, LLC to MMIC Holdings, LLC, a wholly owned subsidiary, on December 31, 2006. In December 2006, the Company formed Leland Holdings, LLC (“Leland Holding”), through its subsidiary, MMIC Holdings, LLC and the Company’s senior executives and other investors. Leland Holding was created to invest in commercial land in Brunswick County, NC.

21

Medical Mutual Insurance Company of North Carolina Notes to the Statutory Financial Statement December 31, 2005

In 2006, the Company entered into a services agreement with MMIC Administrative Services, LLC (“MMIC-AS”) to provide management and administrative services to Valor MD Insurance, LTD (“Valor MD”), an affiliate reinsuring MMIC’s retained net risk on the business written in the State of Georgia. During 2006, MMIC also entered into a quota share agreement with Valor MD to cede the Georgia direct business. This coverage subsequently expanded to include North Carolina, Virginia, and Alabama. In January 2007, the Company formed Legion Road, LLC with Thomas Linderman Graham to build an office condominium located in Chapel Hill, NC.

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Medical Mutual Insurance Company of North Carolina Appendix A – Organization Chart December 31, 2005 and 2004

Medical Mutual Insurance Company of North Carolina Insurer Domicile - NC Medical Security Insurance Company Insurer 100% Owned Domicile - NC

MMIC Agency, Inc. Non-Insurer 100% Owned Domicile - NC

MMIC RPG, Inc. Non-Insurer 100% Owned Domicile - NC

MMIC Lake Partners, LLC Non-Insurer 60% Owned Domicile - NC

MMIC Rex Partners, LLC Non-Insurer 60% Owned Domicile - NC

MMIC Trinity Road Partners, LLC Non-Insurer 60% Owned Domicile - NC

Spring Commons Partners, LLC Non-Insurer Domicile - NC

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Medical Mutual Insurance Company of North Carolina Appendix B – Report Distribution December 31, 2005 and 2004

Allen Dale Jenkins Chief Executive Officer Medical Mutual Insurance Company 700 Spring Forest Road Raleigh, NC 27609 Paul Mark Davidson Chief Financial Officer and Treasurer Medical Mutual Insurance Company 700 Spring Forest Road Raleigh, NC 27609 Steven Sawyer Director of Regulatory Affairs Medical Mutual Insurance Company 700 Spring Forest Road Raleigh, NC 27609

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