Argo Group leases office space in Bermuda where its principal executive offices are located. The Company leases office space in San Antonio, Texas for its United States headquarters and for certain support functions associated with Argonaut Insurance Company and in Edison, New Jersey, where PXRE Reinsurance Company’s principal offices are located. The Company also leases office space in Brussels, Belgium. Other leased headquarters locations for the Company’s operating subsidiaries include offices in Richmond, Virginia (Colony), Rockwood, Pennsylvania (Rockwood), Portland, Oregon (Grocers Insurance), Chicago, Illinois (Select Markets), San Antonio, Texas (Trident), Richmond, Virginia (Argonaut Specialty) and Redwood City, California (Argonaut Insurance Company). Great Central is headquartered in facilities it owns in Peoria, Illinois. In addition, the Company has entered into other leases in conjunction with its operations at various locations throughout the country. The properties are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. Argo Group believes the facilities it occupies are adequate for the purposes for which they are currently used and are well maintained.
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 82. 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.
For the year ended December 31, 2007, Argo Group reported net income of $143.8 million, or $5.58 per fully diluted share, including an extraordinary gain on the closing of the Merger of PXRE and Argonaut Group of $66.3 million, or $2.57 per fully diluted share. Net income for the year ended December 31, 2006 was $106.0 million or $4.82 per fully diluted share and $80.5 million or $3.91 per fully diluted share for the same period in 2005. Gross written premiums increased to $1,180.9 million for the year ended December 31, 2007 from $1,155.6 million and $1,055.7 million for the same periods in 2006 and 2005, respectively. Growth in gross written premiums was primarily the result of a strong renewal process, coupled with new public entity business in the New England area. The Company slightly increased gross written premiums notwithstanding increased competition and pricing pressures in all segments and products. Pre-tax income was favorably impacted by $30.3 million in net favorable loss development.
Losses and loss adjustment expenses for the year ended December 31, 2006 included $44.9 million of favorable development on prior accident years across all lines and segments. Partially offsetting this favorable development was higher than anticipated reserves for the 2006 accident year of $29.1 million due to higher than anticipated emergence of claims in the property, transportation and other liability occurrence lines. Included in losses and loss adjustment expenses for the year ended December 31, 2005 was $20.3 million in favorable development on prior year ultimate losses related to business written in 2004, including $3.0 million of favorable development related to the 2004 hurricanes. Partially offsetting the favorable development recognized during 2005 was an increase to losses and loss adjustment expenses of $10.0 million associated with the commutation of a reinsurance contract in the second half of 2005. Losses and loss adjustment expenses for the year ended December 31, 2005 included losses from hurricane activity of $12.1 million.
Consolidated underwriting, acquisition and insurance expenses were $328.1 million, $285.1 million and $262.5 million for the years ended December 31, 2007, 2006 and 2005, respectively. The higher expense ratio in 2007 as compared to 2006 was primarily attributable to $10.2 million of additional compensation expense resulting from the acceleration of the vesting of certain share-based payment arrangements. 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, for which there was $0.5 million of negative earned premiums due to reinsurance cessions. The improvement in the expense ratio in 2006 as compared to 2005 was primarily the result of higher consolidated earned premiums without a corresponding increase in consolidated fixed costs. Additionally, included in underwriting, acquisition and insurance expenses for 2005 was a charge of $6.2 million associated with the commutation of a reinsurance contract.
Consolidated interest expense and other were $25.2 million, $13.0 million and $15.0 million for the years ended December 31, 2007, 2006 and 2005, respectively. Interest expense resulting from the junior subordinated debentures was $20.9 million in 2007, including $6.0 million resulting from the debentures acquired from PXRE from the date of acquisition through December 31, 2007. Interest expense resulting from the junior subordinated debentures was $12.6 million and $8.9 million for the years ending December 31, 2006 and 2005, respectively. The increase in interest expense on the junior subordinated debentures in 2006 as compared to 2005 was due to rising interest rates, coupled with recording a full year of interest expense on the $30.9 million of debentures issued in December 2005. Interest expense for funds withheld under a retroactive reinsurance contract totaled approximately $5.5 million for the year ended December 31, 2005. The reinsurance contract was commuted during the third quarter of 2005. Also included in consolidated interest expense and other for the year ended December 31, 2007 was $3.5 million resulting from the net change in fair value on derivative reinsurance contracts, and $0.7 million resulting from foreign currency exchange losses on transaction that are settled in currencies other than U.S. dollars.
The Company is primarily engaged in writing property and casualty insurance and reinsurance. Prior to the Merger, Argonaut Group classified its business into two ongoing operating segments: Excess and Surplus Lines and Select Markets. PXRE classified its business prior to the Merger into two reportable property and casualty segments: Catastrophe & Risk Excess and Exited Lines.
Subsequent to the Merger, the Company evaluated its operating segments and management determined that the Company would have three ongoing operating segments: Excess and Surplus Lines and Select Markets segments (which were previously included in Argonaut Group’s ongoing operating segments), and the International Specialty segment. The International Specialty segment is comprised of the operations of Peleus Re, a Bermuda-based subsidiary of the Company that focuses on underwriting medium to small commercial property reinsurance risks on a pro rata and risk excess basis, and property catastrophe reinsurance risk on a controlled basis. The International Specialty segment also includes international reinsurance programs that had previously been reported in Argonaut Group’s Excess and Surplus Lines and Select Markets segments. Amounts applicable to prior periods have been reclassified to conform to the presentation followed after the Merger.
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 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 GAAP as a measure of profitability, management utilizes this measure of profit (loss) to focus its segments on generating operating income which excludes realized gains and losses on sales of investments.
Excess and Surplus Lines. Excess and surplus lines insurance carriers focus on risks that the standard market is unwilling or unable to underwrite due to the unique risk characteristics of the insureds or the lack of insurers offering such coverage, which may be caused by physical perils, the nature of the business or the insured’s loss experience. The Company, through Colony and Argonaut Specialty, its two separate platforms, is able to underwrite these risks with more flexible policy terms at unregulated premium rates to the extent the business is underwritten on an excess and surplus lines basis. Colony provides commercial liability, commercial property, products liability and environmental liability coverages to commercial enterprises, including restaurants, artisan contractors, day-care centers and manufacturers, and professional liability coverages for health care providers and other professionals. Colony is approved as a non-admitted insurer in 49 states, the District of Columbia and the U.S. Virgin Islands. Argonaut Specialty, the Company’s second excess and surplus lines platform, began operations in the second quarter of 2005. Argonaut Specialty provides primary general liability, excess/umbrella coverage and property lines of business for risks the admitted market chooses not to underwrite. Argonaut Specialty’s risks are typically larger than Colony’s and it utilizes a smaller distribution platform.
The following table summarizes the results of operation for the Excess and Surplus Lines segment:
The increase in earned premiums was the result of increased gross written premiums over the earnings cycle for each year reported. Partially offsetting the increase in earned premiums for the year ended December 31, 2007 was a $4.1 million increase in ceded premiums under a property reinsurance contract due to a shortfall in the minimum subject premium under this contract.
Gross written premiums from renewal business increased to $394.9 million for the year ended December 31, 2007 compared to $313.5 million and $243.5 million from the same periods in 2006 and 2005, respectively. A larger base of expiring premiums contributed to the increased renewal premiums, including $75.5 million and $43.0 million in renewal premiums written by Argonaut Specialty for the years ended December 31, 2007 and 2006, respectively.
Included in losses and loss adjustment expense for the year ended December 31, 2006 was favorable development of $33.7 million which was mainly caused by lower than expected loss emergence on the 2004 and 2005 accident years resulting from lower loss frequency. Partially offsetting the favorable development related to prior year loss reserves, during 2006 the Company added $24.3 million in losses for the most recent accident year. Of the $24.3 million, $11.1 million was related to higher than expected property losses and the remainder was associated with casualty business resulting from increased severity, rate changes and an increased net retention. Included in the 2005 loss ratio is $11.2 million in catastrophe losses resulting from the hurricane activity during the latter half of 2005. Partially offsetting the hurricane losses in 2005 was favorable development on prior year losses of $12.7 million, including $5.1 million related to the 2004 hurricanes and $7.6 million related to favorable development on property and casualty lines of business written in 2004 and prior. Loss reserves for the Excess and Surplus Lines segment were $1,084.7 million, $890.9 million and $703.0 million at December 31, 2007, 2006 and 2005.
The increase in the expense ratio to 31.8% for the year ended December 31, 2007 as compared to 31.4% for the same period in 2006 was due primarily to the reduction to earned premiums due to minimum premium penalty discussed above, coupled with higher than expected contingent commissions on the segment’s binding authority units. The increase in the expense ratio to 31.4% for the year ended December 31, 2006 as compared to 31.0% for the same period in 2005 was due primarily to an increase in admitted business (due to the renewal rights acquisition), which typically has higher acquisition costs than non-admitted business, in 2006 as compared to 2005.
The increase in net investment income for the year ended December 31, 2007 as compared to 2006 and 2005 was primarily attributable to higher invested assets resulting from increased cash flows. Invested assets were $1,330.4 million, $1,132.1 million and $818.5 million as of December 31, 2007, 2006 and 2005, respectively.
The Company assumes premiums under various reinsurance programs, including involuntary pools. Gross written premiums assumed under these contracts were $4.3 million, $12.2 million and $8.0 million for the years ended December 31, 2007, 2006 and 2005, respectively. Additionally, gross written premiums by the Corporate Accounts unit were $0.7 million, $1.9 million and $2.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The increase in net investment income for the year ended December 31, 2007 as compared to 2006 and 2005 was primarily attributable to higher invested assets resulting from increased cash flows. Invested assets were $687.7 million, $536.0 million and $473.3 million as of December 31, 2007, 2006 and 2005, respectively.
The increase in earned premiums was the result of growth in gross written premiums from 2006 to 2007. Gross written premiums increased in 2007 as compared to the same period in 2006 primarily due to the introduction of new programs in 2007. Gross written premiums from these new programs totaled $26.6 million for the year ended December 31, 2007, including $1.5 million of gross written premiums attributable to Peleus Re.
Losses and loss adjustment expenses for the year ended December 31, 2007 resulted in a loss ratio of 54.4% compared to 64.3% for the same period ended 2006. The decrease in the loss ratio was primarily attributable to a new program entered into in 2007 which reported a 40.1% loss ratio for the year ended December 31, 2007. Peleus Re recorded losses and loss adjustment expenses of $0.3 million from the date of acquisition through December 31, 2007. Loss reserves for the International Specialty segment were $17.3 million at December 31, 2007.
Upon the completion of the Merger, business previously written by PXRE Bermuda and PXRE Reinsurance Company and classified as property catastrophe, direct casualty, Lloyd’s of London, international casualty and finite is included in the Run-off Lines segment. The Company is no longer actively underwriting business within these programs, and therefore all current activity is related to the management of claims and other administrative functions. The results of operations for the former PXRE business are included beginning on August 7, 2007, the closing date of the Merger.
For the year ended December 31, 2006, the Company strengthened loss reserves for the asbestos and environmental claims by $12.2 million. The Company also increased its unallocated loss adjustment expense reserves by $4.7 million to reserve for the cost to handle and run-off these claims. Partially offsetting these increases was a reduction to the medical malpractice reserves of $7.0 million. During the year ended December 31, 2006, the last two open traditional medical malpractice claims were closed. Only one potential class action suit is still open, and management believes that current reserves adequately represent the Company’s total liability. The Company is beyond the statutes of limitations for filing new medical malpractice claims in all jurisdictions. Losses and loss adjustment expenses in the former risk management lines of $10.3 million for the year ended December 31, 2006 were offset by an equal amount of favorable development on prior accident year reserves. Favorable development consisted of $7.0 million in the workers compensation line due to continued improvement in the 2001 through 2005 accident years due to the impact of California Benefit Reform. The Company recognized $2.6 million in favorable development on involuntary pool losses, and other lines had $0.7 million of favorable development.
In 2005, the Company strengthened the asbestos and environmental unallocated loss adjustment expense reserves by $4.1 million. Losses and loss adjustment expenses for the year ended December 31, 2005 include a $2.0 million increase to the allowance for doubtful accounts related to certain reinsurance treaties from prior accident years. In addition, the 2005 underwriting loss includes a $6.0 million increase to the allowance for doubtful accounts for paid reinsurance balances recoverable to reflect management’s best estimate based on its regular review of these balances. Also included in favorable development for the year ended December 31, 2005, for the risk management lines, was a $6.6 million decrease in other liability reserves resulting from favorable trends on older accident years, offset by $5.5 million of unfavorable development in workers compensation. The unfavorable workers compensation development was driven by $8.0 million of reduced ceded losses from a reinsurance commutation partially offset by favorable development on involuntary pool losses.
The increase in underwriting expenses for the year ended December 31, 2007 as compared to 2006 was primarily attributable to the inclusion of $5.6 million in underwriting expenses for the results of operations of the PXRE run-off, partially offset by the reduction of variable expenses resulting from declining premium volume and reduced administrative expenses in the former risk management lines. Underwriting expenses in 2006 decreased by $21.6 million compared to 2005 as a result of the sale of the risk management renewal rights.
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, 2007:
Annually the Company reviews its loss and loss adjustment expense reserves for its asbestos and environmental claims. The process is initiated at the end of the second quarter and is typically completed in the third quarter of the calendar year. The Company continually monitors the status of the claims, and may make adjustments outside of the annual review period. The review entails a detailed analysis of the Company’s direct and assumed exposure. The Company engages a consulting actuary to provide its best estimate of ultimate losses and management evaluates that estimate in assessing the adequacy of the asbestos and environmental loss and loss adjustment expense reserves.
Total reserves for Run-off Lines as of December 31, 2007 were $697.0 million, net of reinsurance, including reserves for asbestos and environmental claims of $141.4 million. 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 $118.9 million to $200.0 million. In determining its best estimate, management primarily relied on the report year method, with some weight given to other methods. The report year method relies most heavily on the Company's historical claims and severity information, whereas other methods rely more heavily on industry information. This 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. As a result of this reserve analysis, the reserve for incurred but not reported asbestos and environmental claims (net of reinsurance) at December 31, 2007, was $73.1 million compared to $86.5 million and $86.0 million as of December 31, 2006 and 2005, respectively.
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, 2007:
For the year ended December 31, 2007, net cash provided by operating activities was $166.2 million, compared to $299.0 million for the year ended December 31, 2006 and $333.2 million for the year ended December 31, 2005. The decrease in cash flows from operations in 2007 as compared to 2006 was primarily attributable to increased cash outflows for claim payments in 2007 as compared to 2006, coupled with negative cash flow related to the PXRE legacy companies of $68.8 million. The decrease in cash flows from operations in 2006 as compared to 2005 was largely due to the tax payments in 2006 exceeding payments in 2005 by $30.2 million and interest paid on the junior subordinate debentures increased $3.9 million for the year ended December 31, 2006 as compared to 2005 due to higher interest rates.
Net cash used by investing activities totaled $183.3 million, $292.4 million and $414.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. Cash was primarily used to acquire fixed maturity and equity investments, offset by cash received from sales, calls and maturities of fixed maturity securities and sales of equity securities. The Company received net cash of $10.4 million upon the closing of the Merger of PXRE and Argonaut Group in August 2007. The Company received $17.3 million in cash as a result of the sale of a strategic investment during the year ended December 31, 2006. As of December 31, 2007, 2006 and 2005, $621.6 million, $213.2 million and $272.6 million, respectively, of the investment portfolio were invested in short-term, liquid investments.
Net cash provided by financing activities totaled $15.5 million and $7.5 million for the years ended December 31, 2007 and 2006, respectively. Net cash was primarily the result of cash received from stock option exercises. Net cash provided by financing activities totaled $79.5 million for the year ended December 31, 2005, and was primarily attributable to the Company’s issuance of common stock and junior subordinated debentures.
Cash dividends paid to preferred shareholders totaled $0.1 million, $1.4 million and $2.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. In the first quarter of 2007, 500,000 preferred shares and in the second quarter of 2007, all remaining preferred shares converted into the Company’s common stock. In 2006, the decrease in preferred dividends paid was the result of the reduction of preferred shares outstanding (1.0 million shares outstanding at December 31, 2006 compared to 2.4 million shares outstanding at December 31, 2005), coupled with a reduction of the dividend rate from 7% in 2005 to 6% in 2006. The reduction in the dividend rate was the result of an improved risk based capital ratio in 2005 and continuing into 2006.
During 2005, Argonaut Group Statutory Trust X (“Trust X”), a wholly owned subsidiary of Argonaut Group (non-consolidated), sold 30,000 Floating Rate Capital Securities (the “2005 Capital Securities”) (liquidation amount $1,000 per Capital Security) in a private sale for $30.0 million. Trust X used the proceeds from this sale, together with the proceeds from its sale of 928 shares of Floating Rate Common Securities (liquidation amount $1,000 per Common Security) to Argonaut Group, to buy a series of Floating Rate Junior Subordinated Debentures (the “2005 Debentures”) due 2035 from Argonaut Group. The 2005 Debentures have the same payment terms as the 2005 Capital Securities. The 2005 Debentures are unsecured and are subordinate in right of payment to all of the Company’s future senior indebtedness. The initial interest rate on the 2005 Debentures and the 2005 Capital Securities issued by Trust X is fixed at 7.75% for the first 5 years. After 5 years, the interest rate is equal to 3-month LIBOR plus 3.40%, which rate is reset quarterly. After September 15, 2010, Argonaut Group will have the right to redeem the 2005 Debentures, in whole or in part, but in all cases in a principal amount in integral multiples of $1,000, at a price equal to 100% of the principal amount of the 2005 Debentures, plus accrued and unpaid interest to the date of redemption. Argonaut Group also has the right to redeem all of the 2005 Debentures prior to September 15, 2010 upon the happening of specified events at the greater of (i) 107.5% of the principal amount of the 2005 Debentures, plus accrued and unpaid interest to the date of redemption, or (ii) the sum of (a) the discounted present value of the principal amount of the 2005 Debentures, (b) the discounted present value of the interest payable on the 2005 Debentures during the fixed rate period remaining life, and (c) the accrued and unpaid interest on the 2005 Debentures through the redemption date.
During 2003, PXRE, through a series of statutory trusts (non-consolidated), sold $62.5 million of Capital Securities (the “2003 PXRE Capital Securities”) (liquidation amount $1,000 per Capital Security) in a series of private sales. In conjunction with the sales of the 2003 PXRE Capital Securities, the trusts sold $1.9 million of Common Securities to PXRE. The trusts used the proceeds from these sales to purchase $64.4 million of Junior Subordinated Debentures (the “2003 PXRE Debentures”) from PXRE. The interest rate on the 2003 PXRE Debentures and the 2003 PXRE Capital Securities issued by PXRE Capital Trust III is fixed at 9.75% payable quarterly. The interest rates on the 2003 PXRE Debentures and the 2003 PXRE Capital Securities issued by the other trusts are fixed at rates ranging from 7.35% to 7.70% for the first five years. After five years, the interest rates are equal to the 3-Month LIBOR plus a margin ranging from 3.85% to 4.10%, reset quarterly. The 2003 PXRE Debentures are unsecured and are subordinate in right of payment to all of the Company’s future senior indebtedness. The 2003 PXRE Debentures are due 30 years after issuance, but may be redeemed after the five-year anniversary at a price equal to 104.875% to 100% of the principal amount of the 2003 PXRE Debentures, plus accrued and unpaid interest on the date of redemption. PXRE has the option to defer interest payments on the capital trust pass-through securities and redeem them earlier than the due dates, subject to limits and penalties as set out in the relevant indentures.
During 1997, PXRE Capital Trust I (“PXRE Capital Trust”), a Delaware statutory trust and a wholly-owned subsidiary (non-consolidated) of PXRE Delaware, issued $103.1 million principal amount of its 8.85% TRUPS due February 1, 2027 in an institutional private placement. Proceeds from the sale of these securities were used to purchase PXRE Delaware’s 8.85% Junior Subordinated Deferrable Interest Debentures due February 1, 2027 (the “Subordinated Debt Securities”). On April 23, 1997, PXRE Delaware and PXRE Capital Trust completed the registration with the SEC of an exchange offer for these securities and the securities were exchanged for substantially similar securities (the “1997 Capital Securities”). Distributions on the 1997 Capital Securities (and interest on the related Subordinated Debt Securities) are payable semi-annually, in arrears, on February 1 and August 1 of each year, commencing August 1, 1997. On or after February 1, 2007, PXRE Delaware has the right to redeem the Subordinated Debt Securities, in whole at any time or in part from time to time, subject to certain conditions, at call prices of 104.180% at February 1, 2007, declining to 100.418% at February 1, 2016, and 100% thereafter.
The Company invests excess cash in a variety of investment securities. As of December 31, 2007, the Company’s investment portfolio consisted of 73.6% fixed maturities, 8.5% equities, 0.4% other investments and 17.5% short-term investments (based on fair value) compared to 80.6% fixed maturities, 10.3% equities, 0.6% other investments and 8.5% short-term investments for the same period in 2006. The Company classifies its investment portfolio as available-for-sale; therefore all investments are reported at fair market value, with unrealized gains and losses, net of tax, being reported as a component of shareholders’ equity. As of December 31, 2007, the Company had no investment in any one security that exceeded 10% of shareholders’ equity.
The insurance subsidiaries must maintain certain levels of policyholders’ surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners suggest that a property and casualty insurer’s ratio of annual statutory net premium written to policyholders’ surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the U.S. subsidiaries to their combined policyholders’ surplus was 1.2-to-1 as of December 31, 2007. Current levels of policyholders’ surplus are adequate to support current premium writings, based on this standard. The Company monitors premium and statutory surplus levels of the insurance subsidiaries to ensure that the subsidiaries maintain adequate premiums to surplus ratios. Failure of any insurance subsidiary to maintain adequate levels of policyholders’ surplus could negatively impact the ability to write additional premiums.
In addition, regulators and rating agencies utilize a risk based capital (“RBC”) test designed to measure the acceptable amount of surplus an insurer should maintain, based on specific inherent risks of each insurer. Insurers failing to meet this benchmark level may be subject to scrutiny by the insurer’s domiciliary insurance department and potentially result in rehabilitation or liquidation. At December 31, 2007, the total adjusted capital of each of the Company’s U.S. subsidiaries exceeded the minimum levels required under RBC. The Company continually monitors the RBC ratios and will implement strategies to maintain ratios above the regulatory minimums.
The Company invests in the debt securities markets, which exposes it to credit risk. As a consequence of extending credit and/or carrying investment positions, the Company has exposure to credit risk arising from the uncertainty associated with a financial instrument obligor’s ability to make timely principal and/or interest payments. The Company attempts to mitigate this risk by limiting credit concentrations, diversification, and frequently monitoring the credit quality of issuers and counterparties.
The Company controls its credit exposure related to financial instruments by limiting exposure to any one counterparty and mandating minimum credit ratings. The Company utilizes specific criteria to judge the credit quality and liquidity of its investments in addition to a variety of credit rating services to monitor these criteria.