(1) On August 30, 2013, we acquired Kentucky Trailer; on April 26, 2012, we acquired Bourn & Koch; and on March 6, 2012, we acquired TransRe.
The following is a discussion and analysis of our financial condition and results of operations for the twelve months ended December 31, 2014, 2013 and 2012. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties and that are not historical facts, including statements about our beliefs and expectations. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and particularly under the headings “Risk Factors,” “Business” and “Note on Forward-Looking Statements” contained in Item 1A, Item 1, and Part I of this Form 10-K, respectively.
Throughout this Form 10-K, our analysis of our financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with GAAP. Our results of operations have been presented in the way that we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use financial information in evaluating our performance. This presentation includes the use of underwriting profit, which is a “non-GAAP financial measure,” as such term is defined in Item 10(e) of Regulation S-K promulgated by the SEC. Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, other than temporary impairment, or “OTTI,” losses, gain on bargain purchase, other income, other operating expenses, corporate administration, amortization of intangible assets or interest expense. We consistently use underwriting profit as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of our segments and believe that underwriting profit provides useful additional information to investors because it highlights net earnings attributable to a segment’s underwriting performance. Earnings before income taxes may show a profit despite an underlying underwriting loss, and when underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. However, underwriting profit is not meant to be considered in isolation or as a substitute for earnings before income taxes or any other measures of operating performance prepared in accordance with GAAP. A reconciliation of underwriting profit to earnings before income taxes is presented within “Consolidated Results of Operations.”
Earnings before income taxes were $931.9 million in 2014, compared with $855.2 million in 2013 and $719.3 million in 2012.
Net investment income decreased by 1.2 percent in 2014 over 2013, and increased by 48.8 percent in 2013 over 2012.
As of December 31, 2014, we had total assets of $23.5 billion and total stockholders’ equity attributable to Alleghany stockholders of $7.5 billion. As of December 31, 2014, we had consolidated total investments of approximately $18.8 billion, of which $14.6 billion was invested in debt securities, $2.8 billion was invested in equity securities, $0.7 billion was invested in short-term investments and $0.7 billion was invested in other invested assets.
(2) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, OTTI losses, gain on bargain purchase, other income, other operating expenses, corporate administration, amortization of intangible assets or interest expense. Underwriting profit is a non-GAAP financial measure and does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. See “Comment on Non-GAAP Financial Measures” herein for additional detail on the presentation of our results of operations.
(5) The combined ratio is the sum of the loss ratio and expense ratio, all as determined in accordance with GAAP. The combined ratio represents the percentage of each premium dollar a reinsurance or an insurance company has to spend on net loss and LAE, and commissions, brokerage and other underwriting expenses.
2013 vs 2012. The increases in gross premiums written, net premiums written and net premiums earned in 2013 from 2012 primarily reflect increases at our reinsurance segment due to the merger impacts discussed above.
2013 vs 2012. The decrease in net loss and LAE in 2013 from 2012 primarily reflects lower catastrophe losses at our reinsurance and insurance segments and higher net favorable prior year loss and LAE reserve development at our reinsurance segment, partially offset by the merger impacts discussed above. 2012 catastrophe losses include significant losses from Super Storm Sandy. The 2012 net loss and LAE figure related to prior years excludes $87.8 million of favorable prior accident year development on loss and LAE reserves acquired in the merger, which is included in TransRe’s current year net loss and LAE.
Net loss and LAE for 2014, 2013 and 2012 are more fully described in the following pages.
2014 vs 2013. The increase in commissions, brokerage and other underwriting expenses in 2014 from 2013 primarily reflects the impact of increased net premiums earned at our reinsurance and insurance segments, as discussed above, and higher commission rates at our reinsurance segment.
2013 vs 2012. The increase in commissions, brokerage and other underwriting expenses in 2013 from 2012 primarily reflects the merger impacts discussed above.
Commissions, brokerage and other underwriting expenses for 2014, 2013 and 2012 are more fully described in the following pages.
2013 vs 2012. The increase in underwriting profit in 2013 from 2012 primarily reflects lower catastrophe losses at our reinsurance and insurance segments, higher net favorable prior year loss and LAE reserve development at our reinsurance segment and the merger impacts discussed above. 2012 catastrophe losses include significant losses from Super Storm Sandy.
Investment results for 2014, 2013 and 2012 are more fully described in the following pages.
Corporate administration. The increase in corporate administration expense in 2014 from 2013 primarily reflects the absence of a one-time reduction in expenses of $8.8 million from the freezing of pension benefits at the parent level in 2013. The decrease in corporate administration expense in 2013 from 2012 primarily reflects the Transaction Costs of the merger as discussed above.
2014 vs 2013. The slightly higher effective tax rate in 2014 compared with 2013 primarily reflects higher taxable income in 2014 relative to a fairly steady level of tax-exempt interest income arising from municipal bond securities.
2013 vs 2012. The higher effective tax rate in 2013 compared with 2012 primarily reflects the absence of a gain on bargain purchase, which had a significant impact in 2012. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes. The impact of the gain on bargain purchase on the effective tax rate in 2012 was partially offset by the impact of certain non-deductible Transaction Costs in 2012, which resulted in losses before income taxes without a corresponding decrease in income taxes.
2014 vs 2013. The increases in earnings before income taxes and net earnings attributable to Alleghany stockholders in 2014 from 2013 primarily reflect higher underwriting profits at our reinsurance and insurance segments.
2013 vs 2012. Earnings before income taxes increased in 2013 from 2012, whereas net earnings attributable to Alleghany stockholders decreased in 2013 from 2012. These variances primarily reflect the merger impacts discussed above, especially the gain on bargain purchase, which resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes. These variances also reflect substantially lower catastrophe losses in 2013.
The reinsurance segment is comprised of TransRe’s property and casualty & other lines of business. TransRe also writes a modest amount of property and casualty insurance business, which is included in the reinsurance segment. For a more detailed description of our reinsurance segment, see Part I, Item 1, “Business-Segment Information-Reinsurance Segment” of this Form 10-K.
Absent the impact of the merger, gross premiums written and net premiums earned would have decreased in 2013 from 2012. The decrease in gross premiums written reflects an increasingly competitive reinsurance market, which expanded its capacity despite the lack of market need, as well as decisions made by TransRe in recent years to non-renew or reduce participation on certain potentially less profitable treaties and to shift certain business from proportional to potentially more profitable non-proportional exposure. The decrease in net premiums earned primarily reflects a decrease in gross premiums written in earlier quarters. In addition, the decrease in both gross premiums written and net premiums earned reflects the absence of significant assumed reinstatement premiums. $29.8 million of gross premiums written and $25.3 million of net premiums earned were recorded in 2012 related to Super Storm Sandy.
Absent the impact of the merger, gross premiums written and net premiums earned would have decreased in 2013 from 2012. The decrease in gross premiums written reflects an increasingly competitive reinsurance market and a decreasing amount of risk premium being ceded by insurers, as well as decisions made by TransRe in recent years to non-renew or reduce participation on certain potentially less profitable treaties and shift certain business from proportional to potentially more profitable non-proportional exposure. The decrease in net premiums earned primarily reflects a decrease in gross premiums written in recent quarters.
The decrease in net loss and LAE in 2013 from 2012 primarily reflects a decrease in catastrophe losses and an increase in favorable prior accident year development on loss reserves, partially offset by the inclusion of operations from TransRe for the entire 2013 year, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012. Net loss and LAE includes catastrophe losses, net of reinsurance, of $92.1 million in 2013, compared with $252.2 million of catastrophe losses in 2012 related to Super Storm Sandy.
(1) $56.6 million of favorable prior accident year development on loss and LAE reserves acquired in the merger are included in current year net loss and LAE.
(4) Reflects favorable development primarily related to the 2012 accident year and, to a lesser extent, the 2011 accident year.
Casualty & other. The decrease in net loss and LAE in 2014 from 2013 primarily reflects more favorable prior accident year development on loss reserves in 2014 and lower losses incurred for the current accident year. The increase in net loss and LAE in 2013 from 2012 primarily reflects the inclusion of operations from TransRe for the entire 2013 year, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012, partially offset by a lower loss ratio in the current accident year including an absence of catastrophe losses in 2013, compared with $26.2 million of catastrophe losses, net of reinsurance, incurred in 2012 related to Super Storm Sandy.
(3) Generally reflects favorable development in a variety of casualty & other lines of business primarily from the 2003 through 2007 and 2010 through 2011 accident years, partially offset by unfavorable development from the 2013 accident year and the 2002 and prior accident years.
(4) Generally reflects favorable development in a variety of casualty & other lines of business.
Property. The decrease in underwriting profit in 2014 from 2013 primarily reflects the increase in net loss and LAE and commissions, brokerage and other underwriting expenses, partially offset by an increase in net premiums earned, all as discussed above. The increase in underwriting profit in 2013 from 2012 primarily reflects an increase in net premiums earned and a decrease in net loss and LAE, partially offset by an increase in commissions, brokerage and other underwriting expenses, all as discussed above.
Casualty & other. The underwriting profit in 2014 compared with the underwriting loss in 2013 reflects a decrease in net loss and LAE, partially offset by a decrease in net premiums earned and an increase in commissions, brokerage and other underwriting expenses, all as discussed above. The underwriting loss in 2013 compared to an underwriting profit in 2012 reflects an increase in net loss and LAE and commissions, brokerage and other underwriting expenses, partially offset by an increase in net premiums earned, all as discussed above.
Insurance Segment: Premiums. The following table summarizes premiums for the insurance segment.
PacificComp. The increases in gross premiums written and net premiums earned in 2014 from 2013 and in 2013 from 2012 primarily reflect PacificComp’s distribution initiatives and increased market acceptance of PacificComp’s product offerings.
(1) Alleghany commenced reporting catastrophe losses for CapSpecialty on April 1, 2014.
RSUI. The increase in net loss and LAE in 2014 from 2013 primarily reflects the impact of higher net premiums earned, partially offset by a more favorable prior accident year development on loss reserves and a decrease in catastrophe losses. The decrease in net loss and LAE in 2013 from 2012 primarily reflects lower catastrophe losses, net of reinsurance, partially offset by the impact of higher net premiums earned and less favorable prior accident year development on casualty loss reserves.
Net loss and LAE in 2014, 2013 and 2012 include (favorable) unfavorable prior accident year development on loss reserves as shown in the table below:
(1) Primarily reflects favorable development in the professional liability, general liability and umbrella/excess lines of business, and primarily related to the 2006 through 2010 accident years, partially offset by unfavorable development in the directors’ and officers’ liability line of business in the 2011 and 2012 accident years.
CapSpecialty. The decrease in net loss and LAE in 2014 from 2013 primarily reflects substantially less unfavorable development on loss reserves in 2014, partially offset by the impact of higher net premiums earned and higher property losses. Higher property losses in 2014 arose from fire and weather-related losses. The increase in net loss and LAE in 2013 from 2012 primarily reflects an increase in net unfavorable prior accident year development on loss reserves, primarily from a terminated program.
(1) Represents certain specialty classes of business written through a program administrator in connection with a terminated program related to the 2010 and 2009 accident years and reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
PacificComp. The increases in net loss and LAE in 2014 from 2013 and in 2013 from 2012 primarily reflect the impact of higher net premiums earned. Net loss and LAE includes $2.4 million, $13.2 million and $5.6 million of unfavorable prior accident year development in 2014, 2013 and 2012, respectively. The unfavorable development in 2014, 2013 and 2012 related primarily to the 2009 and prior accident years, and reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods.
RSUI, CapSpecialty and PacificComp. The increases in commissions, brokerage and other underwriting expenses for the insurance segment in 2014 from 2013, and in 2013 from 2012, is due primarily to the impact of higher net premiums earned.
PacificComp. PacificComp reported underwriting losses in 2014, 2013 and 2012 primarily as a result of its ongoing expenses relative to comparatively low premiums earned and unfavorable prior accident year development on loss reserves. The decreases in underwriting losses in 2014 from 2013 is primarily due to less unfavorable prior accident year development on loss reserves and increases in net premiums earned, all as discussed above.
Net Investment Income. The increase in net investment income for the reinsurance and insurance segments in 2014 from 2013 is due primarily to more favorable reinvestment rates at TransRe as well as an increased allocation of our debt securities portfolio to higher yielding securities, partially offset by the impact of changes in foreign currency exchange rates. The higher yielding securities relate primarily to an increased allocation to investment-grade and below investment-grade credit instruments managed through our investment management relationship with Ares.
The increase in net investment income for the reinsurance and insurance segments in 2013 from 2012 is due primarily to the inclusion of operations from TransRe for the entire 2013 year, compared with only 300 days subsequent to the TransRe Acquisition Date for 2012. Aside from the impact of the merger, the increase in net investment income reflects higher income from other invested assets, as well as higher interest and dividend income.
(2) After investment expenses and excluding net realized gains and OTTI losses.
recoverable depending on market conditions at the time of disposition. Of the $36.3 million of OTTI losses incurred during 2014, $28.7 million relate to equity securities, primarily in the mining sector, and $7.6 million relate to debt securities, primarily in the energy sector. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity of the decline in the fair value of equity securities relative to their cost as of the balance sheet date, and the fact that we lacked the intent to hold debt securities for a period of time sufficient to allow for an anticipated recovery.
OTTI losses in 2012 reflect $2.9 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $2.9 million incurred during 2012, $1.7 million relate to equity securities, primarily in the energy sector, and $1.2 million relate to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in the fair value of such securities relative to their cost as of the balance sheet date.
See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on gross unrealized investment losses for debt and equity securities as of December 31, 2014.
In July 2014, ACC acquired a 30 percent equity interest in Jazwares, a toy and consumer electronics company, headquartered in Sunrise, Florida, for $60.3 million. Jazwares is accounted for under the equity-method of accounting and is included in corporate activities for segment reporting purposes. Corporate activities include the results of Bourn & Koch beginning April 26, 2012 and Kentucky Trailer beginning August 30, 2013.
Net investment income. The decreases in net investment income in 2014 from 2013 and 2013 from 2012 primarily relate to Homesite, which was sold on December 31, 2013. Net investment income for corporate activities for 2014, 2013 and 2012 was as follows:
Net realized capital gains. Net realized capital gains in 2014 primarily reflect gains from the sale of equity securities. Net realized capital gains in 2013 primarily reflect the sale of Homesite on December 31, 2013, partially offset by sales of equity securities at a realized capital loss. Net realized capital gains in 2012 primarily reflect gains from the sale of shares of Exxon Mobil Corporation common stock held at the corporate-level in the first quarter of 2012.
Gain on bargain purchase. The gain on bargain purchase in 2012 reflects the merger impacts discussed above.
The decrease in corporate administration expense in 2013 from 2012 primarily reflects the absence of Transaction Costs, which amounted to $33.8 million in 2012.
(Losses) Earnings before income taxes. The net losses before income taxes in 2014 compared with the earnings before income taxes in 2013 primarily reflect a decrease in net investment income and net realized capital gains, and an increase in other expenses, corporate administration expenses and interest expense, partially offset by an increase in other income, all as explained above. The decrease in earnings before income taxes in 2013 compared with 2012 primarily reflects the absence of a gain on bargain purchase in 2013, which was significant in 2012.
Our reinsurance and insurance subsidiaries analyze, at least quarterly, liabilities for unpaid loss and LAE established in prior years and adjust their expected ultimate cost, where necessary, to reflect favorable or unfavorable development in loss experience and new information, including, for certain catastrophe events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid loss and LAE, both favorable and unfavorable, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior accident year loss reserve development. The following table presents the reserves established in connection with the loss and LAE of our reinsurance and insurance subsidiaries on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate loss (including for IBNR) and LAE.
(2) Primarily consists of the following direct lines of business: umbrella/excess; directors’ and officers’ liability; professional liability; and general liability.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2014 and December 31, 2013. Gross and net loss and LAE reserves as of December 31, 2014 decreased from December 31, 2013, reflecting a decrease in our reinsurance segment loss and LAE reserves. The decrease in gross and net loss and LAE reserves in the reinsurance segment primarily reflects favorable prior accident year loss reserve development, loss payments including amounts related to catastrophe events occurring in prior years, and the impact of changes in foreign currency exchange rates.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2013 and December 31, 2012. Gross and net loss and LAE reserves as of December 31, 2013 decreased from December 31, 2012, reflecting a decrease in our reinsurance segment loss and LAE reserves, partially offset by a slight increase in our insurance segment loss and LAE reserves. The decrease in gross and net loss and LAE reserves in the reinsurance segment primarily reflects
Our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines of business, improve risk-adjusted portfolio returns, and enable them to increase gross premium writings and risk capacity without requiring additional capital. Our reinsurance and insurance subsidiaries purchase reinsurance and retrocessional coverages from highly-rated third party reinsurers. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such reinsurance portion not paid by these reinsurers. As such, funds, trust agreements and letters of credit are held to collateralize a portion of our reinsurance and insurance subsidiaries’ reinsurance recoverables, and our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite or assume with multiple reinsurance programs.
As of December 31, 2014, our reinsurance and insurance subsidiaries had total reinsurance recoverables of $1,361.1 million, consisting of $1,289.4 million of ceded outstanding loss and LAE and $71.7 million of recoverables on paid losses. See Part I, Item 1, “Business - Reinsurance Protection” of this Form 10-K for additional information on the reinsurance purchased by our reinsurance and insurance subsidiaries.
We had no allowance for uncollectible reinsurance as of December 31, 2014.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that directly affect our reported financial condition and operating performance. More specifically, these estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from reported results to the extent that estimates and assumptions prove to be inaccurate.
We believe that the reserves for unpaid loss and LAE established by our reinsurance and insurance subsidiaries are adequate as of December 31, 2014; however, additional reserves, which could have a material impact upon our financial condition, results of operations, and cash flows, may be necessary in the future.
Loss Frequency and Severity. Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described above. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs and changes in economic conditions or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to our reinsurance or insurance operating subsidiary. The length of the loss reporting lag affects their ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags), as well as the amount of reserves needed for IBNR. If the actual level of loss frequency and severity is higher or lower than expected, the ultimate losses will be different than management’s estimates. A small percentage change in an estimate can result in a material effect on our reported earnings. The following table reflects the impact of changes, which could be favorable or unfavorable, in frequency and severity on our loss estimates for claims occurring in 2014:
(8) Generally reflects favorable development in a variety of casualty & other lines of business.
(9) Primarily reflects favorable development in the professional liability, general liability and umbrella/excess lines of business, and primarily related to the 2006 through 2010 accident years.
(11) Primarily reflects favorable development in the umbrella/excess liability, general liability, professional liability and directors’ and officers’ liability lines of business, and primarily related to the 2005 through 2008 accident years.
(13) Includes $8.5 million of unfavorable development from Hurricane Katrina, which resulted from a significant claim that settled for more than previously estimated due to an adverse court ruling, partially offset by net favorable development with respect to other property reserves.
(14) Includes $9.7 million of unfavorable development from Hurricane Ike in 2008.
(15) Primarily reflects unfavorable development from workers’ compensation and certain other casualty lines of business, and related primarily to unfavorable loss emergence on a few individual claims, partially offset by favorable development on surety lines of business.
(16) Primarily reflects favorable development in certain casualty and surety lines of business.
Reinsurance. Our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines of business, improve risk-adjusted portfolio returns and enable them to increase gross premium writings and risk capacity for other business without requiring additional capital. Our reinsurance and insurance subsidiaries purchase reinsurance and retrocessional coverages from highly-rated third party reinsurers. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such amounts not paid by their reinsurers. Recoverables recorded with respect to claims ceded to reinsurers under reinsurance contracts are predicated in large part on the estimates for unpaid losses and, therefore, are also subject to a significant degree of uncertainty. In addition to the factors cited above, reinsurance recoverables may prove uncollectible if a reinsurer is unable or unwilling to perform under a contract. Reinsurance purchased by our reinsurance and insurance subsidiaries does not relieve them of their obligations to their own policyholders or cedants. Additional information regarding the use of, and risks related to, the use of reinsurance by our reinsurance and insurance subsidiaries can be found on pages 36 through 38 and page 50 of this Form 10-K. Also see Note 1(f) and Note 5 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our reinsurance recoverables.
Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between willing, able and knowledgeable market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, a three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs are the reporting entity’s own assumptions about market participant assumptions based on the best information available under the circumstances. In assessing the appropriateness of using observable inputs in making our fair value determinations, we consider whether the market for a particular security is “active” or not based on all the relevant facts and circumstances. A market may be considered to be inactive if there are relatively few recent transactions or if there is a significant decrease in market volume. Furthermore, we consider whether observable transactions are “orderly” or not. We do not consider a transaction to be orderly if there is evidence of a forced liquidation or other distressed condition, and as such, little or no weight is given to that transaction as an indicator of fair value.
Mortgage-backed and asset-backed securities are initially valued at the transaction price. Subsequently, we use widely accepted valuation practices that produce a fair value measurement by comparison to transactions in similarly structured instruments, use of discounted cash flows, or option adjusted spread analyses. Unobservable inputs, significant to the measurement and valuation of mortgage-backed and asset-backed securities, include assumptions about prepayment speed and collateral performance, including default, delinquency and loss severity rates. Significant changes to any one of these inputs, or combination of inputs, could significantly change the fair value measurement for these securities.
Fair values for partnership and non-marketable equity investments are initially valued at the transaction price. Subsequently, fair value is based on the performance of the portfolio of investments or results of operations of the investee. Significant improvements or disruptions in the financial markets may result in directionally similar or opposite changes to the portfolio of the investee, depending on how management of the investee has correlated the portfolio of investments to the market. Also, any changes made by the investee to the investment strategy of the non-marketable equity investments could result in significant changes to fair value that have a positive or negative correlation to the performance observed in the equity markets. For those investments whose performance is based on the results of operations within a specific industry, significant events impacting that industry could materially impact fair value. Also, decisions and changes to strategy made by management of the investee could result in positive or negative outcomes, which could significantly impact the results of operations of the investee and subsequently fair value.
We then evaluate those equity securities where the unrealized loss is 20 percent or more of cost as of the balance sheet date or which have been in an unrealized loss position continuously for six months or more preceding the balance sheet date. This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other than temporarily impaired including: (i) market valuation metrics associated with the equity security (such as dividend yield and price-to-earnings ratio); (ii) current views on the equity security, as expressed by either our internal stock analysts and / or by third party stock analysts or rating agencies; and (iii) credit or news events associated with a specific issuer, such as negative news releases and rating agency downgrades with respect to the issuer of the investment.
Debt securities in an unrealized loss position are evaluated for OTTI if they meet any of the following criteria: (i) they are trading at a 20 percent discount to amortized cost for an extended period of time (nine consecutive months or longer); (ii) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; or (iii) we intend to sell or it is more likely than not that we will sell the debt security before recovery of its amortized cost basis.
revenue, credit risk and credit enhancements and pre-refunding. For mortgage and asset-backed securities, we discount our best estimate of future cash flows at an effective rate equal to the original effective yield of the security or, in the case of floating rate securities, at the current coupon. Our models include assumptions about prepayment speeds, default and delinquency rates and underlying collateral (if any), as well as credit ratings, credit enhancements and other observable market data. For corporate bonds, we review business prospects, credit ratings and available information from asset managers and rating agencies for individual securities.
Goodwill and other intangible assets, net of amortization, are recorded as a consequence of business acquisitions. Goodwill represents the excess, if any, of the amount paid to acquire subsidiaries and other businesses over the fair value of their net assets as of the date of acquisition. Other intangible assets are recorded at their fair value as of the acquisition date. A significant amount of judgment is needed to determine the fair values as of the date of acquisition of other intangible assets and the net assets acquired in a business acquisition. The determination of the fair value of other intangible assets and net assets often involves the use of valuation models and other estimates, which involve many assumptions and variables and are inherently subjective. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and intangible assets that have an indefinite useful life are not subject to amortization.
of $133.4 million related primarily to TransRe, RSUI, CapSpecialty, Bourn & Koch and Kentucky Trailer. See Note 1(i) and Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our goodwill and other intangible assets.
of changes in foreign currency exchange rates. The increase in unrealized appreciation on our debt securities portfolio was due to a modest decrease in long-term interest rates that occurred in 2014. As of December 31, 2014, we had 16,054,323 shares of our common stock outstanding, compared with 16,766,192 shares of our common stock outstanding as of December 31, 2013.
Debt. On September 9, 2014, we completed a public offering of $300.0 million aggregate principal amount of our 4.90% senior notes due on September 15, 2044, or the “2044 Senior Notes.” The 2044 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest on the 2044 Senior Notes is payable semi-annually on March 15 and September 15 of each year. The terms of the 2044 Senior Notes permit redemption prior to their maturity. The indenture under which the 2044 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2044 Senior Notes were issued at approximately 99.3 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $294.3 million, and an effective yield of approximately 5.0 percent. Approximately $3.6 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2044 Senior Notes.
On October 15, 2014, TransRe redeemed $300.0 million aggregate principal amount of its 2015 Senior Notes for $324.4 million, consisting of the $300.0 million aggregate principal amount redeemed, $18.6 million of redemption premium and $5.8 million of accrued and unpaid interest to the date of redemption. Of the $324.4 million redemption amount, $297.3 million was funded by a capital contribution from Alleghany primarily using the $294.3 million of net proceeds from Alleghany’s issuance of the 2044 Senior Notes. As a result of this early extinguishment of debt, TransRe recorded a realized loss, before tax, of $9.4 million in 2014.
Alternate Base Rate Borrowings under the Credit Agreement bear interest at (x) the greatest of (a) the administrative agent’s prime rate, (b) the federal funds effective rate plus 0.5 percent, or (c) an adjusted London Interbank Offering Rate, or “Adjusted LIBO Rate,” for a one month interest period on such day plus 1 percent,
The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement requires us to, among other things, (x) maintain consolidated net worth of not less than the sum of (i) $4,223.9 million plus (ii) 50 percent of our cumulative consolidated net earnings in each fiscal quarter thereafter (if positive) commencing on September 30, 2013, and (y) maintain a ratio of consolidated total indebtedness to consolidated capital as of the end of each fiscal quarter of not greater than 0.35 to 1.0. Additionally, the Credit Agreement contains various negative covenants with which we must comply, including, but not limited to, limitations respecting: the creation of liens on any property or asset; the incurrence of indebtedness; mergers, consolidations, liquidations and dissolutions; change of business; sales of assets; transactions with affiliates; anti-terrorism laws and foreign asset control regulations and other provisions customary in similar types of agreements.
TransRe’s operations are also regulated in various foreign jurisdictions with respect to currency, amount and type of security deposits, amount and type of reserves and amount and type of local investment. Regulations
profits and repatriation of assets. International operations and assets held abroad may also be adversely affected by political and other developments in foreign countries, including possible tax changes, nationalization and changes in regulatory policy, as well as by consequences of hostilities and unrest. The risks of such occurrences and their overall effect upon TransRe vary from country to country and cannot easily be predicted.
As of December 31, 2014, a maximum amount of $78.6 million was payable by TRC without prior approval of the New York State Department of Financial Services and a maximum amount of $9.7 million was payable by RSUI without prior approval of the applicable regulatory authorities. The maximum amount of ordinary annual dividends payable by our reinsurance and insurance subsidiaries in 2015 without prior regulatory approval is $635.0 million, consisting of $478.6 million from TRC and $156.4 million from RSUI, respectively, subject to certain timing restrictions based on dividend patterns over the preceding twelve months.
Dividends. From 1987 through 2011, we declared stock dividends in lieu of cash dividends every year except 1998, when our wholly-owned subsidiary, Chicago Title Corporation, was spun off to our stockholders. Our Board of Directors determined not to declare a dividend, cash or stock, for 2012 through 2014.
Capital Contributions. From time to time, we make capital contributions to our subsidiaries. In 2014, we made a $297.3 million capital contribution to TransRe to redeem $300 million par value of the 2015 Senior Notes, as described above. In 2014, we also made capital contributions to ACC to: (i) make $96.6 million of capital contributions to SORC; (ii) exercise an option to increase its ownership in Kentucky Trailer by $15.0 million; and (iii) make a $60.3 million investment in Jazwares. In 2013, we made a $14.7 million capital
contribution to AIHL Re to provide capital to support an intercompany reinsurance contract between AIHL Re and PCIC. In 2013, we made $40.7 million of capital contributions to ACC to make capital contributions to SORC and to make an investment in Kentucky Trailer of $24.9 million. In 2012, we made a $15.0 million capital contribution to PacificComp to provide additional capital support. In 2012, we also made capital contributions to ACC to make an investment in Bourn & Koch of $47.0 million, and to make capital contributions to SORC of $16.2 million. We expect that we will continue to make capital contributions to our subsidiaries from time to time in the future for similar or other purposes.
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2014, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows:
Financial strength is also a high priority of our subsidiaries, whose assets stand behind their financial commitments to their customers and vendors. We believe that our subsidiaries have and will have adequate internally generated funds, cash resources, and unused credit facilities to provide for the currently foreseeable needs of their businesses. Our subsidiaries had no material commitments for capital expenditures as of December 31, 2014.
Investment Strategy and Holdings. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize our risk-adjusted, after-tax rate of return. Our investment decisions are guided mainly by the nature and timing of expected liability payouts, management’s forecast of cash flows and the possibility of unexpected cash demands, for example, to satisfy claims due to catastrophe losses. Our consolidated investment portfolio currently consists mainly of highly rated and liquid debt and equity securities listed on national securities exchanges. The overall debt securities portfolio credit quality is measured using the lowest rating of the Standard & Poor’s Ratings Services, Moody’s Investors Service Inc. or Fitch Ratings. In this regard, the overall weighted-average credit quality rating of our debt securities portfolio as of December 31, 2014 and 2013 was AA-. Although many of our debt securities, which consist predominantly of municipal bonds, are insured by third party financial guaranty insurance companies, the impact of such insurance was not significant to the debt securities credit quality rating as of December 31, 2014. As of December 31, 2014, the ratings of our debt securities portfolio were as follows:
(1) Consists of $200.2 million of securities rated BB / Ba, $291.7 million of securities rated B, $63.0 million of securities rated CCC, $10.9 million of securities rated CC, $4.7 million of securities rates below CC and $23.0 million of not-rated securities.
In the event paid losses accelerate beyond the ability of our reinsurance and insurance subsidiaries to fund these paid losses from current cash balances, current operating cash flow, dividend and interest receipts and security maturities, we would need to liquidate a portion of our investment portfolio, make capital contributions to our reinsurance and
insurance subsidiaries, and / or arrange for financing. Strains on liquidity could result from: (i) the occurrence of several significant catastrophe events in a relatively short period of time; (ii) the sale of investments into a depressed marketplace to fund these paid losses; (iii) the uncollectibility of reinsurance recoverables on these paid losses; (iv) the significant decrease in the value of collateral supporting reinsurance recoverables; or (v) a significant reduction in our net premium collections.
Fair Value. The carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2014 and 2013 were as follows:
(1) This table includes AFS investments (debt and equity securities as well as partnership and non-marketable equity investments carried at fair value that are included in other invested assets). This table excludes investments accounted for using the equity method and certain loans receivable that are carried at cost, all of which are included in other invested assets. The fair value of short-term investments approximates amortized cost. The fair value of all other categories of investments is discussed below.
Level 1: Valuations are based on unadjusted quoted prices in active markets that we have the ability to access for identical, unrestricted assets and do not involve any meaningful degree of judgment. An active market is defined as a market where transactions for the financial instrument occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Our Level 1 assets include publicly traded common stocks and mutual funds (which are included on the balance sheet in equity securities) where our valuations are based on quoted market prices.
We employ specific control processes to determine the reasonableness of the fair values of our financial assets and liabilities. Our processes are designed to ensure that the values received or internally estimated are accurately recorded and that the data inputs and the valuation techniques used are appropriate, consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. We
The estimated fair values of our financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2014 and 2013 were as follows:
Municipal Bonds. The following table provides the fair value of our municipal bonds as of December 31, 2014, categorized by state and revenue source. Special revenue bonds are debt securities for which the payment of principal and interest is available solely from the cash flows of the related projects. As issuers of revenue bonds do not have the ability to draw from tax revenues or levy taxes to fund obligations, revenue bonds may carry a greater risk of default than general obligation bonds.
Projections of potential catastrophe losses are typically expressed in terms of the probable maximum loss, or “PML.” We define PML as our anticipated maximum loss (taking into account contract limits) caused by a single catastrophe event at a specified estimated return period affecting a broad contiguous area. These modeled losses are estimated based upon contracts in force at January 1, 2015 for TransRe, December 1, 2014 for RSUI and August 7, 2014 for PacificComp. Modeled results also reflect losses arising from certain of our invested assets that have specific catastrophe exposures.
The following is an overview of such modeled PMLs from property, engineering, marine and energy exposures and the associated natural perils that we deem most significant. The estimated amount of these modeled losses are presented for both a 100 year return period (having a likelihood of being exceeded in any single year of 1.0 percent), and a 250 year return period (having a likelihood of being exceeded in any single year of 0.4 percent), and are presented in two ways: (i) gross catastrophe losses; and (ii) after-tax net catastrophe costs (that is, gross losses, net of reinsurance, net reinstatement premiums and taxes). The reduction for reinsurance assumes that all reinsurers fulfill their obligations in accordance with contract terms.
There is much uncertainty and imprecision in the compilation of these estimates at many stages in the process. Moreover, the makeup of our in-force business is constantly changing as new business is added and existing contracts terminate or expire, including contracts for reinsurance coverage purchased by us. In addition, these estimates take into account what we believe to be the most likely accumulation of territories, but there can be no assurance that we have captured every possible scenario in our analysis. As a result of these factors, among others, there can be no assurance that we will not experience after-tax net catastrophe costs from individual events that will exceed these estimates by a material amount. There also can be no assurance that we will not experience catastrophe events more frequently than the modeled probabilities would suggest. In any given year, catastrophe events could have a material adverse effect on our financial condition, results of operations, cash flows and liquidity.
In April 2014, the FASB issued guidance that changed the criteria for reporting discontinued operations. Under the new guidance, only disposals that represent a strategic shift in operations qualify as discontinued operations. In addition, the new guidance requires expanded disclosures about discontinued operations. This guidance is effective in the first quarter of 2015. We will adopt this guidance in the first quarter of 2015, and we do not currently believe that the implementation will have an impact on our results of operations and financial condition.
In May 2014, the FASB, together with the International Accounting Standards Board, issued guidance on the recognition of revenue from contracts with customers. Under the new guidance, revenue is recognized as the transfer of goods and services to customers takes place, and in amounts that reflect the payment or payments that are expected to be received from the customers for those goods and services. The new guidance also requires new disclosures about revenue. Insurance- and reinsurance-related revenues are not impacted by this guidance. This guidance is effective in the first quarter of 2017 for public entities, with earlier adoption not permitted. We will adopt this guidance in the first quarter of 2017, and we do not currently believe that the implementation will have a material impact on its results of operations and financial condition.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Alleghany Corporation and subsidiaries at December 31, 2014 and 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alleghany Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 24, 2015 expressed an unqualified opinion thereon.
Alleghany owned a minority stake in Homesite Group Incorporated (“Homesite”), a national, full-service, mono-line provider of homeowners insurance, until its sale to American Family Insurance Company, a Wisconsin-based mutual insurance company, on December 31, 2013.
The accompanying consolidated financial statements include the results of Alleghany and its wholly-owned and majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). All significant inter-company balances and transactions have been eliminated in consolidation. The results of TransRe are included in Alleghany’s consolidated financial statements beginning from the TransRe Acquisition Date, except with respect to “Supplemental Pro Forma Information” included in Note 2(e). In addition, the results of Bourn & Koch have been included in Alleghany’s consolidated
AFS securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to AFS securities, as well as partnership investments that Alleghany accounts for as AFS, are excluded from earnings and reflected in comprehensive income, and the cumulative effect is reported as a separate component of stockholders’ equity until realized. If a decline in fair value is deemed to be other than temporary, the investment is written down to its fair value and the amount of the write-down is recorded as an other than temporary impairment (“OTTI”) loss on the statement of earnings. In addition, any portion of such decline related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than against earnings.
Net investment income consists primarily of: (i) interest income from debt securities, short-term investments and cash, including any premium amortization or discount accretion; (ii) dividend income from equity securities; and (iii) investment income from other invested assets, which generally includes distributions when receivable and earnings from investments accounted for under the equity method; less expenses related to investments. Interest income is accrued when earned. Premiums and discounts arising from the purchase of
certain debt securities are treated as a yield adjustment over the estimated useful life of the securities, adjusted for anticipated prepayments using the retrospective interest method. Under this method, the effective yield on a security is estimated. Such estimates are based on the prepayment terms of the security, past actual cash flows, and assumptions as to future expected cash flow. The future cash flow assumptions consider various prepayment assumptions based on historical experience, as well as current market conditions. Periodically, the effective yield is re-estimated to reflect actual prepayments and updated future cash flow assumptions. Upon a re-estimation, a security’s book value is restated at the most recently calculated effective yield, assuming that yield had been in effect since the security was purchased. This treatment results in an increase or decrease to net investment income (accretion of premium or amortization of discount) at the new measurement date.
Level 1: Valuations are based on unadjusted quoted prices in active markets that Alleghany has the ability to access for identical, unrestricted assets and do not involve any meaningful degree of
Fair values for partnership and non-marketable equity investments are initially valued at the transaction price. Subsequently, fair value is based on the performance of the portfolio of investments or results of operations of the investee, as derived from their financial statements. Significant improvements or disruptions in the financial markets may result in directionally similar or opposite changes to the portfolio of the investee, depending on how management of the investee
Alleghany employs specific control processes to determine the reasonableness of the fair values of its financial assets and liabilities. Alleghany’s processes are designed to ensure that the values received or internally estimated are accurately recorded and that the data inputs and the valuation techniques used are appropriate, consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. Alleghany assesses the reasonableness of individual security values received from valuation service providers through various analytical techniques. In addition, Alleghany validates the reasonableness of fair values by comparing information obtained from Alleghany’s valuation service providers to other third party valuation sources for selected securities. Alleghany also validates prices obtained from brokers for selected securities through reviews by those who have relevant expertise and who are independent of those charged with executing investing transactions.
Unearned premiums and ceded unearned premiums represent the portion of gross premiums written and ceded premiums written, respectively, relating to the unexpired terms of such coverages. Assumed reinsurance premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. These estimates may change when actual data for such estimated items becomes available.
Goodwill and other intangible assets, net of amortization, are recorded as a consequence of business acquisitions. Goodwill represents the excess, if any, of the amount paid to acquire subsidiaries and other businesses over the fair value of their net assets as of the date of acquisition. Other intangible assets are recorded at their fair value as of the acquisition date. A significant amount of judgment is needed to determine the fair values as of the date of acquisition of other intangible assets and the net assets acquired in a business acquisition.
With respect to goodwill, a qualitative assessment is first made to determine whether it is necessary to perform quantitative testing. This initial assessment includes, among other factors, consideration of: (i) past, current and projected future earnings and equity; (ii) recent trends and market conditions; and (iii) valuation metrics involving similar companies that are publicly-traded and acquisitions of similar companies, if available. If this initial qualitative assessment indicates that the fair value of an operating subsidiary may be less than its respective carrying amount, a second step is taken, involving a comparison between the estimated fair values of the operating subsidiary with its respective carrying amount including goodwill. Under GAAP, fair value refers to the amount for which the entire operating subsidiary may be bought or sold. The methods for estimating operating subsidiary values include asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. All of these methods involve significant estimates and assumptions. If the carrying value exceeds estimated fair value, there is an indication of potential impairment, and a third step is performed to measure the amount of impairment. The third step involves calculating an implied fair value of goodwill by measuring the excess of the estimated fair value of the operating subsidiary over the aggregate estimated fair values of the individual assets less liabilities. If the carrying value of goodwill exceeds the implied fair value of goodwill, an impairment charge is recorded for the excess.
Assets and liabilities denominated in foreign currencies are translated into U.S. dollars at period-end exchange rates. Income and expense accounts are translated at average exchange rates for the year. The resulting unrealized currency translation gain or loss for functional currencies is recorded, net of tax, in accumulated other comprehensive income, a component of stockholders’ equity.
Certain prior year amounts have been reclassified to conform to the 2014 presentation of the financial statements.
In May 2014, the FASB, together with the International Accounting Standards Board, issued guidance on the recognition of revenue from contracts with customers. Under the new guidance, revenue is recognized as the transfer of goods and services to customers takes place, and in amounts that reflect the payment or payments that are expected to be received from the customers for those goods and services. The new guidance also requires new disclosures about revenue. Insurance- and reinsurance-related revenues are not impacted by this guidance. This guidance is effective in the first quarter of 2017 for public entities, with earlier adoption not permitted. Alleghany will adopt this guidance in the first quarter of 2017, and Alleghany does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
On November 20, 2011, Alleghany entered into an Agreement and Plan of Merger (the “Merger Agreement”) with its wholly-owned subsidiary Shoreline Merger Sub, LLC (subsequently converted into a corporation) (“Merger Sub”), and Transatlantic Holdings, Inc. (“Old TransRe”). On the TransRe Acquisition Date, Old TransRe was merged with and into Merger Sub, which was renamed “Transatlantic Holdings, Inc.,” and became a wholly-owned subsidiary of Alleghany.
The merger was accounted for using the acquisition method of accounting. Based on the relative voting interests of Alleghany stockholders (approximately 51 percent) and Old TransRe stockholders (approximately 49 percent) in Alleghany post-merger, the composition of Alleghany’s Board of Directors and senior management after the merger and other factors, it was determined that Alleghany was the acquiring entity for accounting purposes. Under the acquisition method of accounting, the assets, liabilities and commitments of TransRe were adjusted to their fair values on the TransRe Acquisition Date. Significant judgment was required to arrive at estimates of fair values.
(c) Fair Value of Net Assets Acquired and Gain on Bargain Purchase
The total fair value of net assets acquired and the gain on bargain purchase as of the TransRe Acquisition Date are calculated as follows (in millions):
Prior to the TransRe Acquisition Date, Old TransRe established a liability for its stock option and restricted stock awards that was previously accounted for as equity, and this liability is reflected in the net book value of net assets acquired prior to fair value adjustments.
An explanation of the adjustments for fair value is as follows:
Deferred acquisition costs - Elimination of TransRe’s deferred acquisition costs asset.
All other assets - Elimination of TransRe’s carried goodwill, deferred debt issuance costs, allowance for doubtful accounts and the recording of fair value adjustments to other asset categories.
An explanation of the intangible assets and related future amortization is as follows:
Value of business in-force - Intangible asset resulting from the adjustment of unearned premiums to the estimated fair value of profit within TransRe’s unearned premiums as of the TransRe Acquisition Date, adjusted for a risk factor. This will be amortized as the contracts for business in-force as of the TransRe Acquisition Date expire.
Trade name - Addition of the estimated fair value of identifiable intangible assets resulting from the merger arising from trade names and trademarks used by TransRe in conducting its business worldwide.
Renewal rights - Addition of the estimated fair value of identifiable intangible assets resulting from the merger arising from renewal rights. This will be amortized over the net earnings pattern of renewed reinsurance contracts, estimated as of the TransRe Acquisition Date.
TransRe’s results have been included in Alleghany’s Consolidated Financial Statements starting from the TransRe Acquisition Date. The following pro forma financial information for the year ended December 31, 2012 is presented for informational purposes only and is not necessarily indicative of the results that would have occurred had the merger been consummated at the beginning of 2012. Significant assumptions used to determine pro forma results include amortization of intangible assets related to the merger and the assumption that Alleghany’s acquisition of TransRe occurred on January 1, 2012 (the “Pro Forma TransRe Acquisition Date”). Transaction Costs and gain on bargain purchase that are included in Alleghany’s financial statements have not been included in the unaudited pro forma consolidated information. The table presents unaudited pro forma consolidated information for the year ended December 31, 2012:
The pro forma results include TransRe’s pre-tax catastrophe losses, net of reinsurance and reinstatement premiums, of $304.4 million in 2012. Of the $304.4 million of catastrophe losses incurred in 2012, $53.7 million was incurred by Old TransRe prior to the TransRe Acquisition Date and is not included in Alleghany’s GAAP net earnings for 2012. In addition, TransRe recorded pre-tax losses and LAE of $19.0 million in 2012 related to the capsizing of the luxury liner, Costa Concordia, off the coast of Italy, of which $15.8 million was incurred by Old TransRe prior to the TransRe Acquisition Date and is not included in Alleghany’s GAAP net earnings for 2012.
The carrying values and estimated fair values of Alleghany’s consolidated financial instruments as of December 31, 2014 and 2013 were as follows:
(2) There were no OTTI losses recorded in net earnings related to Level 3 instruments still held as of December 31, 2014 and 2013.
Net unrealized losses related to Level 3 investments as of December 31, 2014 and 2013 were not material.
The amortized cost or cost and the fair value of AFS securities as of December 31, 2014 and 2013 are summarized as follows:
The amortized cost and estimated fair value of debt securities as of December 31, 2014 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Net investment income for 2014, 2013 and 2012 was as follows:
(1) See Note 4(h) for discussion of the Pillar Investments and the investment in Ares as defined in Note 4(h).
As of December 31, 2014, non-income producing invested assets were insignificant.
Realized capital gains and losses in 2014, 2013 and 2012 generally reflect sales of equity securities. In addition, net realized capital gains in 2014 also include a realized capital gain of $34.0 million from the sales of long-dated U.S. Treasury Strip debt securities in April 2014, some additional realized capital gains taken on debt securities and a $9.4 million realized capital loss on the early redemption of $300 million par value of TransRe’s 5.75% senior notes due on December 14, 2015 (the “2015 Senior Notes”). See Note 8(b) for additional information on the early redemption of the 2015 Senior Notes. Realized capital gains for 2013 included a $46.8
Alleghany holds its equity and debt securities as AFS, and as such, these securities are recorded at fair value. Alleghany continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. The analysis of any individual security’s decline in value is performed in its functional currency. If the decline of a particular investment is deemed temporary, Alleghany records the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, Alleghany writes its cost-basis or amortized cost-basis down to the fair value of the investment and records an OTTI loss on its statement of earnings. In addition, any portion of such decline related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than charged against earnings.
loss in earnings. To the extent that a debt security that is in an unrealized loss position is not impaired based on the preceding, Alleghany will consider a debt security to be impaired when it believes it to be probable that Alleghany will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, Alleghany develops a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate Alleghany will not recover the full amount of its amortized cost basis in the debt security, Alleghany records an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the debt security. If applicable, the difference between the total unrealized loss position on the debt security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.
OTTI losses in 2013 reflect $44.0 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $44.0 million of OTTI losses incurred during 2013, $42.6 million relate to equity securities, primarily in the chemical and energy sectors, and $1.4 million relate to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in the fair value of such securities relative to their cost as of the balance sheet date.
Alleghany may ultimately record a realized loss after having originally concluded that the decline in value was temporary. Risks and uncertainties are inherent in the methodology Alleghany uses to assess other than temporary declines in value. Risks and uncertainties could include, but are not limited to, incorrect assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral, and unfavorable changes in economic conditions or social trends, interest rates or credit ratings.
As of December 31, 2014, the vast majority of Alleghany’s debt securities were rated investment grade, with approximately 4.1 percent of debt securities having issuer credit ratings that were below investment grade or not rated.
Investments with fair values of approximately $1.2 billion as of December 31, 2014, the substantial majority of which were debt securities and equity securities, were deposited with governmental authorities as required by law.
(3) Approximately 96 percent of Alleghany’s reinsurance recoverables balance as of December 31, 2014 was due from reinsurers having an A.M. Best Company, Inc. financial strength rating of A (Excellent) or higher.
The following table indicates property and casualty premiums written and earned for 2014, 2013 and 2012:
RSUI placed its catastrophe reinsurance program for the 2014 to 2015 period on May 1, 2014. The new catastrophe reinsurance program provides coverage in three layers for $600.0 million of losses in excess of a $200.0 million net retention after application of the surplus share treaties and facultative reinsurance. The first layer provides coverage for $300.0 million of losses, subject to a 5.0 percent co-participation by RSUI, in excess of $200.0 million, the second layer provides coverage for $100.0 million of losses in excess of $500.0 million, with no co-participation by RSUI, and the third layer provides coverage for $200.0 million of losses in excess of $600.0 million, with no co-participation by RSUI. In addition, RSUI’s property per risk reinsurance program for the 2014 to 2015 period provides RSUI with coverage for $90.0 million of losses, subject to a 10.0 percent co-participation by RSUI, in excess of a $10.0 million net retention per risk after application of the surplus share treaties and facultative reinsurance.
In the second quarter of 2013, AIHL Re and PacificComp’s wholly-owned subsidiary Pacific Compensation Insurance Company (“PCIC”), entered into an intercompany reinsurance contract, effective January 1, 2013, pursuant to which AIHL Re provides PCIC with coverage for adverse development on net loss and allocated loss adjustment expenses in excess of PCIC’s carried reserves at December 31, 2012 and accident year stop-loss coverage for any net losses and allocated loss adjustment expenses in excess of 75.0 percent of net premiums earned for PCIC for accident years 2013, 2014 and 2015. AIHL Re’s commitments also are intended to cover the statutory collateral requirements at PCIC, if and when necessary. AIHL Re’s obligations are subject to an aggregate limit of $100.0 million. In connection with such intercompany reinsurance agreement, Alleghany and AIHL Re entered into a contract whereby Alleghany will guarantee the recoverable balances owed to PCIC from AIHL Re up to $100.0 million. Subsequent to the entry into the above agreements, A.M. Best Company, Inc. upgraded PCIC’s rating to A- (Excellent) from B++ (Good). The above agreements had no impact on Alleghany’s consolidated results of operations and financial condition. From a segment reporting perspective, the financial results of AIHL Re, which are substantially attributable to its intercompany contract with PCIC, have been included in the results of PacificComp, with all intercompany balances eliminated.
Activity in liability for loss and LAE in 2014, 2013 and 2012 is summarized as follows:
(1) Reinsurance recoverables in this table include only ceded loss and LAE reserves.
(2) For 2014, represents reserves acquired in connection with a loss portfolio transfer transaction. For 2012, represents the carrying value of TransRe’s net reserves acquired in the merger. TransRe’s gross loss and LAE reserves and ceded loss and LAE reserves as of the TransRe Acquisition Date were $9,627.8 million and $471.7 million, respectively.
(3) 2012 includes amounts from TransRe from the TransRe Acquisition Date through December 31, 2012, including $87.8 million of favorable prior accident year development on loss and LAE reserves acquired.
Gross loss and LAE reserves as of December 31, 2014 decreased from December 31, 2013, reflecting a decrease in the reinsurance segment loss and LAE reserves. The decrease in gross loss and LAE reserves in the reinsurance segment primarily reflects favorable prior accident year loss reserve development, loss payments including amounts related to catastrophe events occurring in prior years, and the impact of changes in foreign currency exchange rates.
Gross loss and LAE reserves as of December 31, 2013 decreased from December 31, 2012, reflecting a decrease in the reinsurance segment loss and LAE reserves, partially offset by a slight increase in the insurance segment loss and LAE reserves. The decrease in gross loss and LAE reserves in the reinsurance segment primarily reflects favorable prior accident year development on loss reserves and payments related to catastrophe events occurring in prior years. The slight increase in gross loss and LAE reserves in the insurance segment primarily reflects the impact of higher net premiums earned in 2013, partially offset by the impact of property loss claims resulting from Super Storm Sandy paid by RSUI in 2013.
(17) Represents certain specialty classes of business written through a program administrator in connection with a terminated program related to the 2010 and 2009 accident years and reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
(18) The unfavorable development in 2014, 2013 and 2012 related primarily to the 2009 and prior accident years.
semi-annually on March 15 and September 15 of each year. The terms of the 2020 Senior Notes permit redemption prior to their maturity. The indenture under which the 2020 Senior Notes were issued contains covenants that impose conditions on Alleghany’s ability to create liens on, or engage in sales of, the capital stock of AIHL or RSUI. The 2020 Senior Notes were issued at approximately 99.6 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $298.9 million, and an effective yield of approximately 5.67 percent. Approximately $2.8 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2020 Senior Notes.
The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities as of December 31, 2014 and 2013 are as follows:
A valuation allowance is provided against deferred tax assets when, in the opinion of management, it is more likely than not that a portion of the deferred tax asset will not be realized. Alleghany has recognized $16.6 million of deferred tax assets for certain state net operating and capital loss carryovers. A valuation allowance of $16.6 million has been established against these deferred tax assets as Alleghany does not currently anticipate it will generate sufficient income in these states to absorb such loss carryovers.
Alleghany believes that, as of December 31, 2014, it had no material uncertain tax positions. Interest and penalties relating to unrecognized tax expenses (benefits) are recognized in income tax expense, when applicable. There was no liability for interest or penalties accrued for uncertain tax positions as of December 31, 2014.
Pursuant to the Alleghany Board of Directors authorizations, Alleghany repurchased shares of Common Stock in 2014, 2013 and 2012 as follows:
(1) For 2014, excludes a $9.4 million realized capital loss on the early redemption of the 2015 Senior Notes (see Note 8(b) for additional information). For 2013, excludes a $46.8 million realized capital gain related to the sale of Homesite, and a $5.0 million realized capital loss related to a non-cash impairment charge related to certain finite-lived intangible assets at CapSpecialty.
A summary of dividends paid to AIHL by its operating subsidiaries in 2014, 2013 and 2012 follows:
AIHL’s insurance operating subsidiaries could also pay additional dividends without regulatory approval based on statutory surplus. As of December 31, 2014, of the aggregate total equity of AIHL’s operating subsidiaries of $2.0 billion, a maximum of $9.7 million was available for dividends without prior approval of the applicable regulatory authorities. The maximum for each entity is calculated based on the applicable statute, and in the case of RSUI’s insurance operating subsidiaries, which accounts for the majority of dividend capacity for AIHL, is calculated based on 10 percent of statutory surplus less dividends paid in the prior twelve months and is recalculated on a rolling basis throughout the year.
72,528, 73,072 and 57,981 contingently issuable shares were potentially available during 2014, 2013 and 2012, respectively, but were not included in the computations of diluted earnings per share because the impact was anti-dilutive to the earnings per share calculation.
for the next $100.0 million of such losses, so that Alleghany’s maximum indemnification obligation in respect of products liability claims relating to such period of time is $150.0 million. This indemnification obligation will expire on July 31, 2016. With respect to the Alleghany Period, based on its historical experience and other analyses, in July 2005, Alleghany established a $0.6 million reserve in connection with the Products Liability Indemnification for the Alleghany Period. Such reserve was approximately $0.1 million as of both December 31, 2014 and 2013. The Stock Purchase Agreement provides that Alleghany has no responsibility for products liability claims arising in respect of events occurring after the Closing Date, and that any products liability claims involving both pre-closing and post-closing periods will be apportioned on an equitable basis.
Alleghany and its subsidiaries lease certain facilities, furniture and equipment under long-term lease agreements. In addition, certain land, office space and equipment are leased under non-cancelable operating leases that expire at various dates through 2029. Rent expense was $33.8 million, $28.8 million and $21.2 million in 2014, 2013 and 2012, respectively. The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2014 were as follows:
Loss and LAE include amounts for risks relating to asbestos-related illness and environmental impairment. As of December 31, 2014 and 2013, such gross and net reserves were as follows:
The reserves carried for such claims, including the incurred but not reported portion, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illness and environmental impairment losses, particularly for those occurring in 1985 and prior, which represents the majority of TransRe’s asbestos-related illness and environmental impairment reserves. This uncertainty is due to inconsistent and changing court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible future changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings.
(4) Includes amortization associated with deferred acquisition costs of $1,042.0 million, $973.5 million and $578.1 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Foreign net premiums earned in 2014, 2013 and from the TransRe Acquisition Date through December 31, 2012 were approximately $1.5 billion, $1.6 billion and $1.4 billion, respectively. The foreign country in which Alleghany generates the largest amount of premium revenues is the U.K. Net premiums earned by operations in the U.K. in 2014, 2013 and from the TransRe Acquisition Date through December 31, 2012 were $654.8 million, $661.2 million and $562.9 million, respectively.
As of December 31, 2014, the identifiable assets of the reinsurance segment, insurance segment and corporate activities were $16.3 billion, $6.4 billion and $0.8 billion, respectively, of which cash and invested assets represented $14.3 billion, $4.8 billion and $0.3 billion, respectively. As of December 31, 2014, Alleghany’s equity attributable to the reinsurance segment, insurance segment and corporate activities was $5.1 billion, $2.8 billion and ($0.4) billion, respectively.
Included in corporate activities is debt associated with ACC’s operating subsidiaries. In this regard, SORC had $6.8 million of borrowings as of December 31, 2014, representing its borrowing capacity as of December 31, 2014 pursuant to a secured $250.0 million bank credit facility that was obtained in April 2014. In addition, Kentucky Trailer had $29.2 million of borrowings as of December 31, 2014 related to a mortgage loan and borrowings under its available credit facility. None of these liabilities are guaranteed by Alleghany or ACC, and they are classified as a component of other liabilities.
Three large international brokers accounted for approximately 29 percent, 22 percent and 11 percent in 2014, approximately 27 percent, 22 percent and 11 percent in 2013 and approximately 26 percent, 21 percent and 12 percent from the TransRe Acquisition Date through December 31, 2012, of gross premiums written in the reinsurance segment.
In February 2012, Alleghany adopted the 2012 Long-Term Incentive Plan (the “2012 LTIP”), which was approved by Alleghany stockholders in April 2012. Awards under the 2012 LTIP may include, but are not limited to, cash and / or shares of Common Stock, rights to receive cash and / or shares of Common Stock and options to purchase shares of Common Stock, including options intended to qualify as incentive stock options under the Internal Revenue Code, and options not intended to so qualify. Under the 2012 LTIP, the following types of awards were outstanding as of December 31, 2014:
RSUI has a Restricted Stock Unit Plan (the “RSUI Plan”) for the purpose of providing equity-like incentives to key employees of RSUI. Under the RSUI Plan, restricted stock units (“units”) are issued. Additional units, defined as the “Deferred Equity Pool,” were issued in 2014, 2013 and 2012 and may be created in the future if certain financial performance measures are met. Units may only be settled in cash. The fair value of each unit is calculated as stockholder’s equity of RSUI, adjusted for certain capital transactions and accumulated compensation expense recognized under the RSUI Plan, divided by the sum of RSUI common stock outstanding and the original units available under the RSUI Plan. The units vest on the fourth anniversary of the date of grant and contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2014, 2013 and 2012, RSUI recorded $28.2 million, $27.9 million and $21.0 million, respectively, in compensation expense related to the RSUI Plan. During the same periods, a deferred tax benefit of $9.9 million, $9.8 million and $7.4 million, respectively, related to the compensation expense was recorded.
Long-term incentive plans exist at certain other subsidiaries for the purpose of providing equity-like incentives to key employees. The awards under such plans were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2014.
Alleghany and certain of its subsidiaries provide a variety of retirement benefits. Alleghany provides supplemental retirement benefits through deferred compensation programs and profit sharing plans for certain of its parent-level officers and employees. In addition, Alleghany’s subsidiaries sponsor both qualified, defined contribution retirement plans for substantially all employees, including executives, and non-qualified plans only for executives, some of which provide for voluntary salary reduction contributions by employees and matching contributions by each respective subsidiary, subject to specified limitations.
Alleghany has an unfunded, noncontributory defined benefit pension plan for parent-level executives and a funded, noncontributory defined benefit pension plan for parent-level employees. Prior to September 30, 2013, Alleghany also had two unfunded retiree health plans, one for parent-level executives and one for parent-level employees. On July 16, 2013, the Alleghany Board of Directors decided to: (i) freeze the benefits associated with the unfunded, noncontributory defined benefit pension plan for parent-level executives, effective December 31,
TransRe has an unfunded, noncontributory defined benefit plan and a funded noncontributory defined benefit plan for certain of its employees in the U.S. Benefits under TransRe’s defined benefit plans were frozen as of December 31, 2009. As of December 31, 2014 and 2013, the projected benefit obligation was $66.2 million and $49.8 million, respectively, and the related fair value of plan assets was $49.2 million and $42.4 million, respectively.
Kentucky Trailer had a funded, noncontributory defined benefit plan for certain of its employees, prior to its termination and pay-out in August 2014. Benefits under Kentucky Trailer’s defined benefit plans were frozen in 2005. As of December 31, 2013, the projected benefit obligation was $5.6 million, and the related fair value of plan assets was $4.7 million.
Selected quarterly financial data for 2014 and 2013 are presented below:
We have audited Alleghany Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Alleghany Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
In our opinion, Alleghany Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.