Reinsurance
We use insurance and reinsurance (collectively, "reinsurance") to provide capacity to write larger limits of liability, 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 we pay.
We evaluate each of our ceded reinsurance contracts at inception to determine if there is sufficient risk transfer to allow the contract to be accounted for as reinsurance under current accounting guidance. At September 30, 2007 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 insurance and reinsurance programs. We base our estimation 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. As losses are paid, the related amount expected to be collected from reinsurers is recorded as a receivable in other assets as it no longer relates to our recorded reserves.
We estimate premiums ceded under reinsurance agreements wherein the premium due to the reinsurer, subject to certain maximums and minimums, is based on losses reimbursed or to be reimbursed under the agreement. Our estimates of the amounts due from and to reinsurers are regularly reviewed and updated by management as new data becomes available. Our assessment of the collectibility 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. Appropriate reserves are established for balances we believe may not be ultimately collected.
Given the uncertainty of the ultimate amounts of our losses, our estimates of losses and related amounts recoverable may vary significantly from the eventual outcome. Any adjustments are reflected in then-current operations. Due to the size of our reinsurance balances, even a small adjustment to these estimates could have a material effect on our results of operations for the period in which the adjustment is made.
Investment Valuations
We evaluate our investments on at least a quarterly basis for declines in fair value below cost for the purpose of determining whether these declines represent other than temporary declines. Some of the factors we consider in the evaluation of our investments are:
- the extent to which the fair value of the investments is less than its cost basis,

- the length of time for which the fair value of the investment has been less than its cost basis,

- the financial condition and near-term prospects of the issuer underlying the investment, taking into consideration the economic prospects of the issuer's industry and geographical region, to the extent that information is publicly available, and

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

When we judge a decline in fair value below cost to be other than temporary we reduce the cost basis of the investment to fair value and realize a loss in the current period income statement for the amount of the reduction. In subsequent periods, we base any measurement of gain or loss or decline in value upon the adjusted cost basis of the investment. Deferred Policy Acquisition Costs
Policy acquisition costs, primarily commissions, premium taxes and underwriting salaries, vary directly with, and are primarily related to, the acquisition of new and renewal premiums. Such costs are capitalized and charged to expense as the related premium revenue is recognized. We evaluate the recoverability of our deferred policy acquisition costs and any amounts estimated to be unrecoverable are charged to expense in the current period.

Accounting Changes
We adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes (FIN 48) as of its effective date, January 1, 2007. FIN 48 creates a single model to address accounting for uncertainty in tax positions and clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting for interim periods, disclosure and transition. The cumulative effect of adopting FIN 48 increased retained earnings and reduced our tax liability by $2.7 million.
Recent Accounting Pronouncements and Guidance In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) 157, Fair Value Measurements (SFAS 157). The standard establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. SFAS 157 is applicable to other accounting pronouncements that require or permit fair value measurements but does not require any new fair value measurements. The statement is effective for fiscal years beginning after November 15, 2007, unless early adopted. We will adopt SFAS 157 on its effective date, and do not expect the implementation of SFAS 157 to have a material effect on our results of operations or financial condition.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 allows many financial assets and liabilities and other items to be reported at fair value that are not currently measured at fair value; unrealized gains and losses on items for which the fair value option has been elected would be reported in earnings at each subsequent reporting date. SFAS 159 also establishes new disclosure requirements with respect to fair values. SFAS 159 is effective for fiscal years beginning after November 15, 2007, unless early adopted. We will adopt SFAS 159 on its effective date, but have not completed our determination of the effect of adoption on our results of operations or financial condition. Recent Significant Events
Effective January 1, 2006, we sold our personal lines operations and recognized a gain on the sale of $109.4 million after consideration of sales expenses and estimated taxes. Additional information regarding the sale is provided in Note 3, "Discontinued Operations" of the Notes to the Condensed Consolidated Financial Statements.
Effective August 1, 2006 we acquired Physicians Insurance Company of Wisconsin, Inc. (PIC Wisconsin) in an all stock merger. The acquisition of PIC Wisconsin allowed ProAssurance to expand its medical professional liability business into the state of Wisconsin and adjacent states and into Nevada. This transaction strategically expanded our geographic footprint and was in keeping with our desire to expand our professional liability operations through selective acquisitions. A more detailed description of the merger transaction is provided in Note 2 of the Notes to the Condensed Consolidated Financial Statements.
During the first quarter of 2007 we reached a confidential settlement that ended all litigation and appeals stemming from, and related to, a $217 million judgment on a malpractice verdict against insureds of one of our subsidiaries entered in Tampa, Florida in October 2006. The effect of the settlement has been reflected in our financial statements.
On April 2, 2007 our Board authorized $150 million to repurchase our shares or debt securities. The timing and quantity of any repurchase is dependent upon market conditions and any changes in ProAssurance's capital requirements, as well as limitations imposed by applicable securities laws and regulations, and the rules of the New York Stock Exchange. As of September 30, 2007 we have repurchased approximately 764,000 common shares at a total cost of approximately $41.3 million. On October 15, 2007 we announced our decision to utilize $16 million of the authorization to redeem our outstanding 2032 Subordinated Debentures on December 4, 2007.

A. Derrill Crowe, M.D. retired as Chief Executive Officer (CEO), effective July 1, 2007 and remains as non-executive Chairman of our Board. The Board of Directors elected W. Stancil Starnes to succeed Dr. Crowe as CEO. Mr. Starnes formerly served as President, Corporate Planning and Administration, of Brasfield & Gorrie, LLC, a large commercial construction firm. Prior to October 2006, Mr. Starnes served as the Senior and Managing Partner of Starnes & Atchison, LLP, Attorneys at Law, and was extensively involved with ProAssurance and its predecessor companies in the defense of its medical liability claims. Reclassifications
Due to the increasing significance of the amounts involved, we have separately stated our investments in unconsolidated subsidiaries and our equity in the earnings of unconsolidated subsidiaries. Previously, investments in unconsolidated subsidiaries were included as a component of other investments, and earnings of unconsolidated subsidiaries were considered as a component of net investment income. The reclassification had no effect on income from continuing operations, net income or total assets. 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 it has no other business operations, dividends from its operating subsidiaries represent a significant source of funds for its obligations, including debt service. The ability of our insurance subsidiaries to pay dividends is subject to limitation by state insurance regulations. See our discussions under "Regulation of Dividends and Other Payments from Our Operating Subsidiaries" in Part I, and in Note 15 of our Notes to the Consolidated Financial Statements in our December 31, 2006 Form 10K for additional information regarding dividend limitations. At September 30, 2007 we held cash and investments of approximately $233 million outside of our insurance subsidiaries that are available for use without regulatory approval. Cash Flows
The principal components of our cash flow are the excess of net investment income and premiums collected over net losses paid and operating costs, including income taxes. Timing delays exist between the collection of premiums and the ultimate payment of losses. 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 reinsurance recoveries.
Our operating activities provided positive cash flows of approximately $207.2 million during the nine months ended September 30, 2007, which is composed of $163.6 million from routine insurance operations and proceeds of $43.6 million related to the sale of trading securities. In 2006, cash provided by operating activities of $134.5 million is composed of net positive cash flows from routine insurance operations of $236.4 million, offset by tax payments related to the sale of our personal lines operations of approximately $54.6 million and purchases of trading securities of approximately $47.4 million.
Exclusive of cash flows related to trading securities and the taxes paid on the MEEMIC transaction, the decline in operating cash flows during 2007 is principally attributable to an increase in payments for losses and loss adjustment expenses (gross loss payments), net of reinsurance reimbursements received (net loss payments). A number of factors influenced the growth in losses paid, including the maturing of the loss reserves established during the last several years of growth, and an increase in the number of large indemnity payments.
Two metrics commonly used to analyze the operating cash flows of insurance companies are the paid-to-incurred ratio and the paid loss ratio.

                                        Three Months Ended         Nine Months Ended
                                           September 30              September 30
                                         2007          2006         2007         2006
         Paid-to-incurred ratio(1)        98.2 %       59.7 %        94.5 %      60.0 %
         Paid loss ratio(2)               63.8 %       45.5 %        66.7 %      45.9 %

(1) Net loss payments divided by net losses and loss adjustment expenses

(2) Net loss payments divided by net earned premiums

Our paid-to-incurred and paid loss ratios are higher in 2007 than in 2006, primarily due to the 2007 increase in net loss payments. The ratios also increased in 2007 because the denominators of each ratio (net losses and loss adjustment expenses for the paid-to-incurred ratio; net earned premiums for the paid loss ratio) decreased in 2007 as compared to 2006. For a long-tailed business such as ProAssurance, the ratios for a short period of time should not be viewed in isolation. And, the ratios are less meaningful in periods of changing volume or in periods in which we have recorded amounts related to prior accident years.
The timing of our indemnity payments are affected by many factors, including the nature of the claims in process in any one period and the speed at which cases work through the trial and appellate process. The contractual obligations table included in our December 31, 2006 Form 10K included a projected pay out schedule for our December 31, 2006 reserves. In that table, which was largely based on historical payment patterns, we projected gross loss payments of approximately $546 million during 2007. To-date in 2007, our gross loss payments total approximately $349 million, which, when annualized, is consistent with the amount estimated for purposes of the table.
Cash flows in 2007 were also reduced due to a decline in premium receipts. These decreases to operating cash flows were partially offset by growth in cash flows from investment earnings, a reduction in premium payments to our reinsurers and lower federal tax payments. Investments
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 as well as the expected cash flows to be generated by our operations. At our insurance subsidiaries the primary outflow of cash is related to the payment of claims and expenses. 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 have an unanticipated shortfall in cash we may either liquidate securities or borrow funds under previously established borrowing arrangements. However, given the relatively short duration of our investments, we do not foresee any such shortfall.
We held cash and short-term securities of $281.7 million at September 30, 2007 as compared to $213.4 million at December 31, 2006. Since December 31, 2006 we have chosen to hold more funds in our short-term portfolio both as a means of managing the duration of our overall investment portfolio, and as a means of increasing our flexibility in a volatile marketplace.
During the third quarter of 2007 we sold the securities held in our fixed maturities trading portfolio (primarily treasury indexed) because we believed active trading of these securities no longer offered superior returns.
Other investments increased from $39.5 million at December 31, 2006 to $58.4 million at September 30, 2007. In January 2007 we contributed high-yield asset-backed bonds from our available-for-sale investment portfolio to a fund created for the purpose of managing such investments. We maintain a direct beneficial interest in securities originally contributed to the fund, which are included in our Balance Sheet as a component of other investments at fair value ($18.7 million at September 30, 2007). Cash flows from our initial investment in the fund, which approximate $8.2 million to-date at September 30, 2007, are being re-invested in an undivided interest of the fund. The undivided interest is considered as an investment in an unconsolidated subsidiary and is accounted for using the equity method.
As of September 30, 2007 our available-for-sale fixed maturity securities of $3.20 billion comprise 88% of our total investments. The approximate $60 million net increase as compared to our December 31, 2006 holdings reflects the investment of operating cash flows, offset by a decline in fair value attributable to higher interest rates (as discussed below).

Substantially all of our fixed maturities are either United States government agency obligations or investment grade securities as determined by national rating agencies. Our available-for-sale fixed maturities have a dollar weighted average rating of "AA+" at September 30, 2007. The weighted average effective duration of our fixed maturity securities at September 30, 2007 is 4.24 years; the weighted average effective duration of our fixed maturity securities and our short-term securities combined is 3.92 years.
Changes in market interest rate levels generally affect our net income to the extent that reinvestment yields are different than the yields on maturing securities. Changes in market interest rates also affect the fair value of our fixed maturity securities. On a pre-tax basis, at September 30, 2007 our available-for-sale fixed maturity securities had net unrealized losses of approximately $10.4 million with gross unrealized losses totaling $27.1 million and gross unrealized gains of $16.7 million. At December 31, 2006, on a pre-tax basis, our available-for-sale fixed maturity securities had net unrealized losses of approximately $2.5 million with unrealized losses totaling $25.2 million and unrealized gains totaling $22.7 million. Almost all of the unrealized loss positions in our portfolio are interest-rate related. Due to the duration of our overall portfolio and our positive operating cash flows, we believe we have the ability and intent to hold these bonds to recovery of book value or maturity and do not consider the declines in value to be other than temporary. For a discussion of the potential effects that future changes in interest rates may have on our investment portfolio see Item 3, "Quantitative and Qualitative Disclosures about Market Risk." Equity investments represent less than 1% of our total investments and less than 2% of our capital at both September 30, 2007 and December 31, 2006. At September 30, 2007, the carrying value of our equity investments (including equities in our available-for-sale and trading portfolios) totaled $21.4 million as compared to $14.9 million at December 31, 2006. Reinsurance
At September 30, 2007 our reinsurance recoverable on unpaid losses is $344.7 million. Our receivable from reinsurers on paid losses, which is classified as a part of other assets, is $42.1 million.
We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance broker assists us 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.
We have not experienced significant difficulties in collecting amounts due from reinsurers due to the financial condition of the reinsurer. Periodically, reinsurers may dispute our claim for reimbursement from them. 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 significant 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.
Periodically, we reach commutation agreements with our reinsurers wherein we agree to terminate an existing reinsurance contract(s) for a specified final settlement. Premiums ceded and reinsurance recoveries are adjusted in the current period as necessary to reflect the amounts specified in the commutation agreement.
During the third quarter of 2007, we commuted all of our outstanding reinsurance arrangements with Alea London Limited for approximately $2.0 million in cash. The transaction decreased premiums ceded for the quarter by approximately $1.9 million and decreased reinsurance recoveries by approximately $0.4 million.

Debt
   Our long-term debt at September 30, 2007 is comprised of the following.

                                                        in thousands, except %
                                                                                        First
                                            Rate                2007               Redemption Date
Convertible Debentures              3.9%, fixed             $     105,899          July 2008
2034 Subordinated Debentures        9.4%, Libor adjusted           46,395          May 2009
2032 Subordinated Debentures        9.6%, Libor adjusted           15,464          December 2007
                                    7.7%, fixed until                              May 2009*
2034 Surplus Notes                  May 2009                       11,753

                                                            $     179,511

* Subject to approval by the Wisconsin Commissioner of Insurance

Our Convertible Debentures may be converted at the option of holders when the price of our common stock exceeds a specified price during 20 of the last 30 days of any quarter. Upon conversion, holders will receive 23.9037 shares of common stock for each $1,000 principal amount of debentures surrendered for conversion. The criterion allowing conversion was met during the quarter ended September 30, 2007 and holders may convert through December 31, 2007. To-date, no holders have requested conversion. If converted, we have the right to deliver cash or a combination of cash and common stock, in lieu of common stock.
We intend to redeem the 2032 Subordinated Debentures in December, 2007. A more detailed description of our debt is provided in Note 8 of the Notes to the Condensed Consolidated Financial Statements. Litigation
We are involved in various legal actions arising primarily from claims against us related to insurance policies and claims handling, including, but not limited to, claims asserted by our policyholders. Legal actions are generally divided into two categories: Legal actions dealing with claims and claim-related actions which we consider in our evaluation of our reserve for losses and legal actions falling outside of these areas which we evaluate and reserve for separately as a part of our Other Liabilities.
Claim-related actions are considered as a part of our reserving process under the guidance provided by SFAS 60 Accounting and Reporting by Insurance Enterprises. We evaluate the likely outcomes from these actions giving . . .