The Company’s reserves are continuously reviewed in accordance with professional actuarial standards. A variety of statistical and actuarial techniques are used to analyze current claim costs, frequency and severity data, and prevailing economic, social and legal factors. Other variables such as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverage, changes in claims handling practices and inflation are also taken into consideration. Management considers not only monetary increases in the cost of what the Company insures, but also changes in societal factors that influence jury verdicts and case law, the Company’s approach to claim resolution, and, in turn, claim costs. The Company’s reserves are analyzed by considering a range of estimates bounded by a high and low point, and records their best estimate within that range. Management considers a “best estimate” to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures. The Company’s actuaries conduct a full reserve study using these methodologies every six months, from which point estimates of ultimate losses and LAE by line of business are selected. These “target” loss ratios are used to determine loss and allocated LAE expectations each month by accident year within each line of business. Each month, reported losses are reviewed against these expectations to evaluate loss emergence trends.
The Company’s environmental pollution reserves have been developing as expected over the past few years with new reports trending downward. In many cases, claims are being settled for less than initially anticipated due to improved site remediation technology and effective policy buybacks. However, due to the high level of uncertainty, revisions to these reserve estimates could have a material impact on the Company’s results of operations in the period recognized and the ultimate actual payments for claims and LAE could turn out to be significantly different from estimates.
For further discussion of loss development in each year, see “-Underwriting Results-Losses and Loss Adjustment Expenses”. For further discussion of investment results, see “-Investment Results”, “-Liquidity and Capital Resources” and Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The accident year loss and LAE ratio increased from 63.2% for accident year 2002 to 75.7% for accident year 2004. This increase primarily reflects the effects of hurricanes Charley, Frances, Ivan and Jeanne of $96 million in 2004, including reinsurance reinstatement premiums of $13 million. Catastrophes added 12.7, 4.3 and 0.3 points to the Company’s accident year loss and LAE ratio in 2004, 2003 and 2002, respectively, and added approximately 58.6, 15.9 and 1.3 points to the property accident year loss and LAE ratios, respectively. The accident year loss and LAE ratios represent management’s estimate, as of December 31, 2004, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “-Critical Accounting Policies and Estimates-Losses and loss adjustment expenses”.
The property loss ratio increase of approximately 70.7 percentage points from accident year 2002 to 2004 reflects higher catastrophe losses in 2004 and reductions in pricing.
In July 2004, the Company executed short sales totaling approximately $200 million of SPDRs. The Company has no contractual timeframe within which it must purchase the SPDRs it previously sold. The table above represents management’s best estimate of the timing of the purchase of the SPDRs. The actual purchase date may differ from that estimate. For additional information on the SPDRs transaction, see “-Investment Results” and Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
As discussed in Note 3 to the consolidated financial statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.
Crum & Forster was established for the purpose of holding the capital stock of Crum & Forster Holding Inc. (“Holding”), another wholly-owned subsidiary of Fairfax Inc., and had no operations prior to becoming the parent of Holding. On June 5, 2003, a merger of entities under common control occurred at historical cost, whereby the capital stock of Holding was contributed to Crum & Forster and, accordingly, Crum & Forster became the parent of Holding. The consolidated financial statements of Holding and its subsidiaries have become the Company’s historical financial statements.
The Company’s investments in Northbridge Financial Corporation (“Northbridge”), HWIC Asia Fund (“HWIC”), Odyssey Re Holdings Corp. (“Odyssey”), Pacific Century Fund I (“Pacific”), TRG Holding Corporation (“TRG”) and MFXchange Holdings Inc. (“MFX”) are accounted for using the equity method and are included in other invested assets on the consolidated balance sheets. Earnings from Northbridge, Odyssey, TRG and MFX are included in equity in earnings of investees, net of tax on the consolidated statements of income. Earnings from HWIC and Pacific are included in investment income on the consolidated statements of income. The Company’s investment in Zenith National Insurance Corp. (“Zenith”), Advent Capital (Holdings) PLC (“Advent”) and Russel Metals Inc. (“Russel”) are carried at fair value and are included in equity securities on the consolidated balance sheets. Changes in the fair value of Zenith, Advent and Russel are recorded in accumulated other comprehensive income, net of tax.
In December 2003, the Company redeemed approximately 1.8 million shares in HWIC at $33.50 per share in order to realize an investment gain for statutory accounting purposes. HWIC is an investment fund owned 98.5% by Fairfax and affiliates, which invests primarily in a diversified portfolio of listed equity and equity-related securities in Asia. In order to complete the redemption, HWIC liquidated a portion of the fund, selling underlying securities to third parties. Total proceeds from the redemption were $59,999 and the Company realized a gain on the redemption in the amount of $15,717. The Company reinvested $75,000 in HWIC during 2004.
Concurrent with the issuance of the Notes, the Company entered into a non-interest bearing standby credit agreement, subordinate to the Notes, whereby Fairfax agreed, under certain conditions, to lend up to $40,000 to Crum & Forster in order to meet certain corporate obligations. Borrowings under this agreement, if any, are due in June 2018. Through December 31, 2004, there have been no borrowings under this agreement.
A Master Repurchase Agreement between the Company and Fairfax, effective July 1, 2000, provides for the repurchase of securities transferred to Fairfax in order to provide liquidity. The Company is obligated to repurchase from Fairfax securities transferred at a price equal to the amount initially raised from their sale plus the stated interest rate of each security pursuant to its initial sale. There were no transactions conducted under this arrangement in 2004, 2003 or 2002.
The Company receives income from subleases of office space to Fairfax affiliates. Sublease income received from affiliates in 2004, 2003 and 2002 amounted to $399, $398 and $349, respectively.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 5.75% and 6.0% at December 31, 2004 and 2003, respectively. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2004, the health care cost trend rates are assumed to decline gradually from 8.5% for participants under age 65 and 10.5% for participants over age 65 in 2004 to 5.25% for all participants in the year 2010 and thereafter. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation at December 31, 2004 by $1,256, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2004 by $72. Conversely, decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation at December 31, 2004 by $923, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2004 by $39. The Company’s expected contribution to the Plan in 2005 is $1,387.
The Company has purchased structured settlement annuities from various insurance companies in order to settle certain claim liabilities. Should these other companies become unable to make the annuity payments, the Company would be liable. The value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2004 and 2003 was approximately $152,022 and $151,873, respectively. Approximately 76.3% of this balance is due from insurance companies rated A or better by A.M. Best Company.