Argo Group leases office space in Bermuda, where its principal executive offices are located. Argo Group US leases office space in San Antonio, Texas, for its United States headquarters, its Commercial Specialty subsidiary company, and for certain support functions associated with Argonaut Insurance Company. Argo Group also leases space in the following locations:
on pages 39 - 70 and the consolidated financial statements and notes thereto, included in Item 8 “Financial Statements and Supplementary Data” beginning on page.
(a) On May 14, 2008, the Company effectively acquired all the outstanding stock of Argo International. Operating results from Argo International are included in the consolidated statement of income from May 31, 2008.
(c) Net income per common share is adjusted for the effects of the 6.484 exchange ratio and for the 1-for-10 reverse stock split which was effective August 7, 2007.
The following discussion should be read in conjunction with the consolidated financial statements and related notes beginning on page. This discussion contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.
The increase in consolidated gross written premiums and earned premiums for the year ended December 31, 2009 as compared to the same periods in 2008 and 2007 was primarily attributable to the operations of Argo Re and Argo International. Earned premiums from Argo International were $424.1 million for the year ended December 31, 2009 compared to $183.4 million from the date of acquisition through December 31, 2008. Earned premiums from Argo Re were $75.4 million for the year ended December 31, 2009 compared to $52.4 million and $1.0 million for the years ended December 31, 2008 and 2007, respectively. Argo Re began operations during the third quarter of 2007. Most of the Company’s product lines have experienced increased competition and/or reduced rates during 2009, with the exception of Argo Re where property catastrophe pricing increased relative to 2008. Earned premiums for the year ended December 31, 2008 were reduced by $3.5 million for net reinstatement premiums related to property catastrophe reinsurance contracts as a result of hurricane activity in 2008.
Consolidated gross realized gains were $47.4 million for the year ended December 31, 2009, as compared to $22.1 million and $12.4 million in 2008 and 2007, respectively. Consolidated gross realized losses were $64.1 million, $57.2 million and $6.5 million for the years ended December 31, 2009, 2008 and 2007, respectively. Included in consolidated gross realized losses for the years ended December 31, 2009, 2008 and 2007 were write downs of approximately $45.0 million, $51.3 million and $2.3 million, respectively, from the recognition of other-than-temporary impairments on certain investment securities.
Consolidated losses and loss adjustment expenses were $853.1 million for the year ended December 31, 2009, compared to $724.9 million and $526.9 million for the same periods in 2008 and 2007, respectively. Included in consolidated losses and loss adjustment expenses for the year ended December 31, 2009 was $6.3 million in favorable loss reserve development on prior accident years. The Excess and Surplus Lines segment had favorable loss development of $15.4 million primarily within the property, casualty and professional liability lines of business. The Commercial Specialty segment had favorable loss development across multiple lines. The Reinsurance segment had favorable loss development of $9.1 million, including $3.6 million of favorable development attributable to Hurricane Ike. The International Specialty segment had unfavorable loss development of $23.5 million, which was offset by additional premiums of $24.1 million primarily within the property lines of business. The Run-off Lines segment had $1.6 million of net favorable development primarily driven by $10.8 million favorable development on legacy PXRE claims, partially offset by $9.1 million of unfavorable reserve development in the U.S run-off lines, including $6.1 million in unfavorable reserve development in asbestos and environmental lines.
The following table summarizes the above referenced reserve development as respects to prior year loss reserves by line of business for the year ended December 31, 2009:
When determining reserve levels, the Company recognizes that there are several factors that present challenges and uncertainties to the estimation of loss reserves. Examples of these uncertainties include growth over the last several years in both the Excess and Surplus Lines and Commercial Specialty segments, and changes to the reinsurance structure. The Company’s net retained losses vary by product and they have generally increased over time. To properly recognize these uncertainties, actuarial reviews have given significant consideration to the paid and incurred Bornhuetter-Ferguson methodologies. Compared with other actuarial methodologies, the paid and incurred Bornhuetter-Ferguson methods assign smaller weight to actual reported loss experience, with the greatest weight assigned to an expected or planned loss ratio. The expected or planned loss ratio has typically been determined using various assumptions pertaining to prospective loss frequency and loss severity. In setting reserves at December 31, 2009, the Company continued to consider the paid and incurred Bornhuetter-Ferguson methods for recent years.
Consolidated loss reserves were $3,203.2 million (including $227.9 million of reserves attributable to Argo International’s Trade Capital providers), $2,996.6 million (including $183.3 million of reserves attributable to the Trade Capital providers) and $2,425.5 million (which excludes $135.7 million of loss reserves which are classified as “Liabilities held for sale”) as of December 31, 2009, 2008 and 2007, respectively. Management has recorded its best estimate of loss reserves as of December 31, 2009 based on current known facts and circumstances. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development, favorable or unfavorable, will not occur.
Consolidated underwriting, acquisition and insurance expenses were $517.9 million, $407.1 million and $328.1 million for the years ended December 31, 2009, 2008 and 2007, respectively. Expense ratios for the years ended December 31, 2009 and 2008 were comparable at 36.6% and 36.2%, respectively. Included in consolidated underwriting, acquisition and insurance expenses for the year ended December 31, 2008 was $63.0 million resulting from Argo International. Included in consolidated underwriting, acquisition and insurance expenses for the year ended December 31, 2007 was $10.2 million of additional compensation expense resulting from the acceleration of the vesting of certain share-based payment arrangements prior to the Merger. Additionally, included in consolidated underwriting, acquisition and insurance expenses was $18.8 million resulting from the operations of PXRE for the period from the closing date of the Merger through December 31, 2007.
The Company is primarily engaged in writing property and casualty insurance and reinsurance. The Company has four ongoing reporting segments: Excess and Surplus Lines, Commercial Specialty, Reinsurance and International Specialty. Additionally, the Company has a Run-off Lines segment for products that it no longer underwrites.
In evaluating the operating performance of its segments, the Company focuses on core underwriting and investing results before consideration of realized gains or losses from the sales of investments. Management excludes realized investment gains and losses from segment results, as decisions regarding the sales of investments are made at the corporate level. Although this measure of profit (loss) does not replace net income (loss) computed in accordance with generally accepted accounting principles in the United States (“GAAP”) as a measure of profitability, management utilizes this measure of profit (loss) to focus its reporting segments on generating operating income.
Losses and loss adjustment expenses for the year ended December 31, 2009 resulted in a loss ratio of 66.1%, compared to 60.2% and 57.5% for the same periods ended 2008 and 2007, respectively. Included in losses and loss adjustment expenses for the year ended December 31, 2009 was $19.4 million in higher than anticipated losses attributable to the 2009 accident year primarily within the professional, casualty and property lines. Partially offsetting the increased expense for accident year 2009 was $15.4 million in favorable loss reserve development on prior accident years within the casualty, professional liability and property lines.
Included in losses and loss adjustment expenses for the year ended December 31, 2008 was $12.7 million in losses resulting from the 2008 hurricane activity. Additionally, $16.7 million of increased losses for the 2008 accident year were recorded for other storm losses and fire losses. Included in losses and loss adjustment expense for the year ended December 31, 2008 was $39.6 million in favorable loss reserve development on prior accident years primarily driven by property lines for the 2006 and 2007 accident years and general liability lines written on both claims-made and occurrence forms related to accident years 2005 and 2006.
The expense ratio increased to 33.5% for the year ended December 31, 2009 compared to 33.1% for the same period in 2008. The increase in the expense ratio in 2009 as compared to 2008 was attributable to a reduction in the deferral of acquisition expenses due to declining premium volumes and to increased expenses in the first quarter of 2009 associated with a 2008 acquisition. The increase in the expense ratio for the year ended December 31, 2008 as compared to the same period ended 2007 was primarily attributable to rate declines and reinstatement premiums.
The overall $6.4 million increase in earned premiums for the year ended December 31, 2009 as compared to the same period in 2008 was primarily attributable to growth in the public entity product lines due to an acquisition that expanded business into the New England region in 2008. Earned premiums for the public entity products increased $13.2 million, from $113.7 million for the year ended December 31, 2008 to $126.9 million for the same period in 2009. Additionally, earned premiums in the surety lines increased $5.3 million from $0.2 million for the year ended December 31, 2008 to $5.5 million for the same period in 2009. These increases in earned premiums were partially offset by a decrease in earned premiums for the Company’s coal mining business due to the effects of a planned shift to large deductible policies which began in 2008. Coal mining business earned premiums decreased $8.1 million, from $74.5 million for the year ended December 31, 2008 to $66.4 million for the same period in 2009. Additionally, earned premiums in Argo Select decreased $5.6 million from $146.9 million for the year ended December 31, 2008 to $141.3 million for the same period in 2009 primarily due to discontinued programs. The increase in earned premiums for the year ended December 31, 2008 as compared to the same period of 2007 was primarily attributable to growth within the public entity and a specialty program which incepted in the fourth quarter of 2007. The Commercial Specialty segment has experienced pricing pressure for the year ended December 31, 2009 compared to the same periods in 2008 and 2007.
The increase in the loss ratio in 2008 versus 2007 was primarily attributable to increased losses for the 2008 accident year. The increased losses for the year ended December 31, 2008 included $2.8 million in losses resulting from hurricane activity and $12.5 million in other property losses, primarily attributable to other storm activity and $12.3 million in casualty losses, workers compensation and commercial automobile lines. Additionally in 2008, the Commercial Specialty segment recognized $8.2 million of net favorable development primarily comprised of $5.0 million of favorable development in an assumed Directors and Officers program, $4.0 million of favorable development in workers compensation lines, $1.5 million of favorable development in property lines, $3.8 million of favorable development in other liability lines and $6.1 million of adverse development in commercial automobile products.
Included in losses and loss adjustment expenses for the year ended December 31, 2007 was $14.8 million in net favorable development on prior accident years. The favorable development consisted of $7.6 million in workers compensation reserves primarily for accident years 2004 through 2006 due to lower loss frequency and lower losses on the large deductible policies in addition to $4.1 million for workers compensation occupational disease for accident years 1998 and prior. Favorable development for general liabilities and automobile lines totaled $7.2 million for accident years 2002 through 2005 and $0.4 million for property lines due to lower than expected frequency and severity. Included in losses and loss adjustment expenses for the 2007 accident year was $2.5 million attributable to storm losses which occurred in December 2007 in the Northwest and Midwest. Workers compensation reserves for the 2007 accident year included $4.4 million of additional reserves due to increased frequency of claims, including a $0.5 million mining accident. Loss reserves for the 2007 accident year within the public entity products were increased by $2.5 million for the property lines and $1.7 million for the commercial automobile and other lines.
Loss reserves for the Reinsurance segment were $76.0 million, $59.8 million and $17.3 million at December 31, 2009, 2008 and 2007, respectively.
The International Specialty segment was formed in May 2008 with the purchase of Heritage, renamed Argo International. As a result, financial results for the two periods presented below are not directly comparable with the table including the last seven months from the acquisition date for the period ended December 31, 2008, and the full year for the year ended December 31, 2009. The following table summarizes the results of operations for the International Specialty segment:
Earned premiums represent the portion of gross written premiums retained by Argo Underwriting Agency with 2009 representing a full year compared to the final seven months from acquisition for 2008. Earned premiums for 2009 were increased by approximately $43.3 million in respect of property binder premiums from prior exposures reported to the Company during 2009.
Losses and loss adjustment expenses are reported net of losses ceded to the trade reinsurers. The loss ratio for the year ended December 31, 2009 was 57.6% and was lower than the prior year loss ratio of 77.9% primarily due to lower catastrophe losses in 2009. Included in losses and loss adjustment expenses for the year ended December 31, 2008 was $40.7 million in losses resulting from hurricanes Gustav and Ike. Unfavorable loss reserve development on prior accident years during 2009 was $23.5 million which was offset by additional premiums of $24.1 million, both of which were primarily related to the property binder business. Included in 2008 losses and loss adjustment expenses was $3.5 million of unfavorable loss development related to property facultative claims from the 2006 year of account.
Earned premiums for the year ended December 31, 2009 were primarily attributable to adjustments resulting from final audits, reinstatement premiums and other adjustments on policies previously written. Earned premiums for the year ended December 31, 2008 were reduced by $15.0 million in ceded premiums due to the expiration of a reinsurance contract in 2008, in addition to decreased reinstatement premiums on reinsurance programs previously written. Earned premiums for the year ended December 31, 2007 were primarily attributable to adjustments resulting from final audits and other adjustments on policies previously written.
Losses and loss adjustment expenses for the year ended December 31, 2009 included $1.6 million in net favorable loss reserve development on prior accident years. The favorable development included $7.6 million of favorable loss reserve development for PXRE non-catastrophe lines and $3.2 million of favorable development related to PXRE’s 2005 hurricane losses. Partially offsetting the favorable development was $6.1 million in unfavorable reserve development resulting from the settlement of one large asbestos claim in the first quarter of 2009 and $3.0 million unfavorable reserve development related to workers compensation reserve discount.
The following table represents a reconciliation of total gross and net reserves for the Run-off Lines for each of the years in the three-year period ended December 31, 2009. Amounts in the net column are reduced by reinsurance recoverables.
The following table represents the components of gross loss reserves for the Run-off Lines for each of the years in the three-year period ended December 31, 2009:
Management uses various actuarial methods to determine its best estimate of losses for the asbestos and environmental exposure within the Run-off Lines segment, which resulted in a range of potential ultimate liability, net of reinsurance, of $68.2 million to $140.8 million. In determining its best estimate, management primarily relied on a method that projects future reported claims and severities, with some weight given to other methods. This method relies most heavily on the Company’s historical claims and severity information, whereas other methods rely more heavily on industry information. The method produces an estimate of losses which have been incurred but not yet reported based on projections of future claims and the average severity for those future claims. The severities were calculated based on the Company’s specific data and in management’s opinion best reflect the Company’s liabilities based upon the insurance policies issued.
The following table represents a reconciliation of the number of asbestos and environmental claims outstanding for each of the years in the three-year period ended December 31, 2009:
Settlement of the litigation referenced above accounted for $19.5 million of the $34.5 million in direct claim payments made in 2009.
The primary sources of cash flow for the Company and its subsidiaries are premiums, reinsurance recoverables, proceeds from sales and redemptions of investments and investment income. The primary cash outflows are claim payments, loss adjustment expenses, reinsurance costs and operating expenses. The nature of insurance is that cash collected for premiums written is invested, interest and dividends are earned thereon, and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of the Company’s loss and loss expenses are paid out over more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payroll and general overhead expenses. Management believes that cash receipts from premiums, proceeds from investment sales and redemptions and investment income are sufficient to cover cash outflows in the foreseeable future. Should the need for additional cash arise, the Company believes it has access to additional sources of liquidity.
In addition, the Company’s ability to receive dividends from its downstream subsidiaries is subject to the ability of each parent corporation within the corporate ownership structure to receive dividends from its respective subsidiary(ies), based upon the subsidiary’s domiciliary regulations. Argo Re is the primary direct subsidiary of Argo Group and is subject to Bermuda insurance laws. Argo Ireland is indirectly owned by Argo Re and is a mid-level holding company subject to Irish laws, and its primary subsidiary is Argo Group US. Argo Group US is a mid-level holding company subject to Delaware laws. Argo Group US is the parent of all of the Company’s U.S. insurance subsidiaries.
The payment of dividends by Argo Re is limited under Bermuda insurance laws, which require Argo Re to maintain certain measures of solvency and liquidity. As of December 31, 2009, Argo Re’s solvency and liquidity margins and statutory capital and surplus were in excess of the minimum levels required by the Insurance Act. As of December 31, 2009, the unaudited statutory capital and surplus of Argo Re was estimated to be $1,269.2 million and the amount required to be maintained was estimated to be $239.9 million, thereby allowing Argo Re the potential to pay dividends or capital distributions within the parameters of the solvency and liquidity margins. The Company believes that the dividend and capital distribution capacity of Argo Re will provide the Company with sufficient liquidity to meet its operating and debt service commitments, as well as other obligations that may arise from time to time.
As a mid-level holding company, Argo Ireland is largely dependent on dividends or other permitted payments from Argo Group US to fund its operating expenses and to fund dividends or share capital reductions to Argo Re. Argo Group US is a mid-level holding company owned by Argo Ireland and is largely dependent on dividends and other permitted payments from its insurance subsidiaries to fund its operating expenses, fund debt service, or to fund dividends to Argo Ireland. Each holding company is subject to their respective domiciliary regulations and tax laws. The Company believes that Argo Ireland and Argo Group US each have sufficient dividend and capital distribution capacity to meet the operating and capital needs of their parents.
The Company has two additional LOC facilities totaling $400 million that allow it to provide LOCs to its ceding companies if such LOC is required under the terms of the contract, and to Lloyd’s to be filed on behalf of Argo (No. 604) Limited. All of the facilities require the Company to provide collateral in the form of fixed maturity securities or cash to the issuing bank as security for the outstanding LOCs. The Company also has two LOC facilities that have been terminated but still have outstanding LOCs. The Company no longer has the ability to issue new LOCs from these facilities but the existing LOCs shall be maintained by the issuing banks. The Company must transfer eligible assets to collateral banks prior to each respective bank issuing an LOC. Since eligible assets include fixed income investments, such securities need not be sold in order to qualify as eligible collateral. At December 31, 2009, the Company has pledged assets with a fair value of $128.9 million to support outstanding letters of credit.
LOCs have been filed with Lloyd’s under a third party property deed on behalf of the Trade Capital providers. LOCs have been filed as part of the terms of whole account quota share reinsurance contracts entered into by the Trade Capital reinsurers. In the event such LOCs are funded, the outstanding balance would be the responsibility of the Trade Capital providers.
Through a series of trusts, that are wholly-owned subsidiaries (non-consolidated), the Company issued debt. The debentures are variable and fixed rate, with the variable rate being reset periodically and subject to certain interest rate ceilings. Interest payments are payable quarterly or semiannually. The debentures are all unsecured and are subordinated to other indebtedness. All are redeemable five years after issuance subject to certain terms and conditions at a price equal to 100% of the principal plus accrued and unpaid interest, except as noted in the footnotes to the following table. These obligations are summarized as follows:
(1) Redeemable at a price equal to 104.875 to 100% of the principal, plus accrued and unpaid interest
The Company assumed debt through the acquisition of Argo International. At December 31, 2009, the outstanding balance on this debt was $69.2 million. The total debt is comprised of two U.S. denominated notes (issued in 2005 and 2006) and three Euro denominated notes (issued 2005, 2006 and 2007). The debt is unsecured, and each note has an option to repay in full on any interest payment date following the fifth anniversary of issue. No principal payments were made on these notes during 2009 or during the seven months ended December 31, 2008. These notes mature beginning in 2034.