The following selected financial data are derived from the Company’s consolidated financial statements. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included under
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 40. 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.
Argonaut Group, Inc. is a national provider of specialty insurance products designed to meet the needs of targeted insured groups. The Company has continued its strategy initiated in 2001 of diversifying its product line and expanding geographically. For the year ended December 31, 2001, risk management (formerly known as specialty workers’ compensation) premiums accounted for approximately 53% of the Company’s gross written premiums. For the year ended December 31, 2003, risk management premiums declined to 25% of the Company’s gross written premiums, whereas excess and surplus lines and specialty commercial accounted for 49% and 18% of gross written premiums, respectively.
Consolidated net investment income reflects the impact of lower investment yields on higher invested assets due to positive cash flows from operations and capital raising initiatives for the year ended December 31, 2003. Total invested assets were approximately $1,553.2 million, $1,181.3 million and $1,153.2 million as of December 31, 2003, 2002 and 2001, respectively.
Excess and Surplus Lines. Excess and surplus lines insurance carriers provide insurance that is unavailable or difficult to obtain by businesses in the admitted market due to the unique characteristics of the insureds or the lack of insurers writing such coverage. The excess and surplus lines market allows Colony to underwrite certain risks with more flexible policy terms at unregulated premium rates. 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 48 states, the District of Columbia and the U.S. Virgin Islands. Colony was acquired by the Company effective September 1, 2001, and its results from operations are included from this date.
counts have increased only 0.1% since the beginning of 2002 indicating that the premium growth in the past two years was primarily the result of increased rates. Loss reserves for the excess and surplus lines segment were $345.5 million, $180.1 million and $138.7 million as of December 31, 2003, 2002 and 2001, respectively. Loss reserves as of December 31, 2003 represent management’s best estimate based on current facts and trends within this segment; however, due to the inherent uncertainties in estimating ultimate loss reserves, the potential for future development exists.
The expense ratio for the year ended December 31, 2003 improved to 29.2% as compared to 31.3% for 2002, and 33.4% for the four months ended December 31, 2001. Underwriting expenses grew at a slower pace than earned premiums enabling the Company to realize this improvement in the expense ratio.
Losses and loss adjustment expenses of $100.2 million, $94.5 million and $129.2 million for the years ended 2003, 2002 and 2001, respectively, equate to loss ratios of 81.9%, 86.5% and 102.1%. Loss reserves for this segment were $653.7 million, $630.0 million and $622.2 million as of December 31, 2003, 2002 and 2001, respectively. As of December 31, 2003, 2002 and 2001, the following is certain claims data with respect to the risk management segment:
Losses and loss adjustment expenses for the year ended 2003 include adverse development of approximately $5.0 million attributable to one multi-year construction account that was non-renewed in January of 2003 and a $5.0 million charge related to an increase in the allowance for doubtful accounts for balances due from reinsurers. In the aggregate, the adverse development and increase to the allowance account resulted in an increase of approximately eight points in the 2003 calendar year loss ratio. Losses and loss adjustment expenses in 2002 include approximately $13.0 million (approximately 12 points of the stated loss ratio) related to the construction account noted above. Losses and loss adjustment expenses in 2001 included reserve strengthening of approximately $7.0 million related workers’ compensation claims in California.
For the last half of 2003, the expense ratio for the risk management segment was approximately 42.0%, which is more reflective of the underwriting expenses of this segment. Due to the loss sensitive nature of the business underwritten by risk management, the expense ratio is higher than if the business were written on a guaranteed cost basis. This is due to the insured receiving a premium credit for participating in the losses on the policy while the costs to underwrite the policy are similar to guaranteed cost.
Gross written premiums increased approximately 12.0% for the year ended December 31, 2003 as compared to 2002 primarily due to rate increases. Gross written premiums for the year ended December 31, 2003 included approximately $110.6 million of renewal premiums compared to $96.9 million for the same period of 2002. The increase in the renewal gross written premiums was primarily the result of rate increases of approximately 8%. Gross written premiums on new business were approximately $33.3 million for the year ended December 31, 2003, compared to $31.1 million for the same period in 2002. The increase in gross written premium from December 31, 2001 to 2002 was primarily attributable to the acquisition of Rockwood, which contributed approximately $21.7 million, combined with an average rate increase of 20.9% at Argonaut Great Central. The increase in earned premiums was primarily attributable to the increases in gross premiums written for all years presented.
The increase in gross written premiums was primarily the result of new business written in 2003 and 2002. For the years ended December 31, 2003 and 2002, the public entity segment’s new business was approximately $33.1 million and $21.9 million, respectively. Additionally, the segment wrote $29.4 million of renewal business, of which $2.5 million represented rate increases in 2003. In 2002, the segment wrote $11.9 million of renewal business, of which $1.6 million represented rate increases.
The expense ratio for the year ended December 31, 2003 was 31.5% compared to 32.2% in 2002 and to 26.8% for 2001. The decrease in the expense ratio in 2003 is primarily a result of lower expense growth compared to the premium growth, partially offset by the decrease in ceding commission on the segment’s quota share reinsurance agreement from 2002 to 2003. The increase in the expense ratio from 2001 to 2002 primarily resulted from a reduced ceding commission on the segment’s quota share reinsurance agreement.
Run-off Lines. The Company has discontinued active underwriting of certain lines of business. The Company is still obligated to pay losses incurred on these lines which include general liability and medical malpractice policies written in past years. The lines currently in run-off are typically characterized by long elapsed periods between the occurrence of a claim and ultimate resolution of the claim. The Company utilizes a specialized staff dedicated to administer and settle these claims.
Argonaut Insurance Company also assumed risk as a reinsurer for a limited period of time, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance Company reinsured risks on policies written by direct carriers. Such reinsurance typically provided coverage for limits attaching at a relatively high dollar amount which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance Company are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no current medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that claims generated out of this population of claimants may result in incurred losses generally lower than the asbestos claims filed over the past decade and could be below Argonaut Insurance Company’s attachment level.
The following table represents a reconciliation of total gross and net reserves for the run-off lines for each of the years in the three-year period ended December 31, 2003. Amounts in the net column are reduced by reinsurance recoverables.
The Company completed its 2002 annual analysis of reserves for the run-off lines in the fourth quarter of 2002 and as a result strengthened its asbestos reserves by $52.8 million. The decision to strengthen asbestos reserves was the result of an evaluation and review of exposure to asbestos claims, particularly in light of industry and litigation trends, actual claims experience, and actuarial analysis by the Company’s consulting and internal actuaries. However, some
uncertainty remains regarding the severity and frequency of future claims to the extent that other carriers and policyholders may not have provided notice of loss or addressed issues of coverage. Additional uncertainty is created by continued unfavorable trends in the insurance industry related to asbestos. All of these factors were considered as part of the decision to strengthen reserves in the fourth quarter of 2002. Although legislative reform for class action lawsuits, judicial and legislative actions imposing minimum proof requirements, and other tort-related reforms are possible in the near term, the study did not take these mitigating factors into account in evaluating the severity or frequency of claims.
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, 2003.
The number of claims opened during the three years ended December 31, 2003 were from the following sources:
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2003.
The Company, through its subsidiary Argonaut Insurance Company, has been named in various legal actions filed by Western MacArthur Company, Western Asbestos Company and certain other individual claimants. Argonaut Insurance Company’s involvement in these actions stems from nine construction wrap-up policies with an occurrence limit of $200,000 per policy issued to Western MacArthur Company and Western Asbestos Company, respectively, for liability arising out of work performed on five construction sites in the 1960’s and 1970’s. Management estimates that approximately 1% of the liabilities associated with previous suits and the entry of default judgments were associated in any way with the operations covered by the Argonaut policies before any adjustment for other applicable coverage and without a determination as to whether Argonaut would be bound by those judgments. Argonaut has in the ordinary course of business established loss reserves and loss adjustment expense reserves in connection with these claims. Based on the above circumstances, management’s evaluation of the Company’s exposure to the Western MacArthur litigation remains unchanged.
The Company’s principal cash flow sources are premiums and investment income. The primary cash outflows are claim payments and operating expenses. The nature of insurance is that cash collected on premiums written is invested, interest and dividends are earned thereon, and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of the Company’s loss and loss expenses are paid out over more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payrolls and general overhead expenses.
During the first quarter of 2003 the Company sold a parcel of real estate in Torrance, California, for approximately $24.0 million. The Company received $4.8 million in cash and issued a note receivable for the remainder, which is secured by the property. In December 2003, the Company received a payment on the note of approximately $1.3 million. The note is due November 30, 2004 and bears interest at 3.5% annually. The maturity date of the note will be automatically extended to May 31, 2005 provided the buyer remits a payment of approximately $0.6 million on or before November 23, 2004. If the maturity date is extended, the interest rate will increase to 4.5%. The buyer has the option to extend the maturity date to November 30, 2005 by remitting a payment of approximately $0.6 million on or before May 24, 2005, at which time the interest rate will increase to 5.5%.
During the first quarter of 2003, the Company sold certain parcels of real estate located in Los Angeles and Goleta, California for $40.0 million under three separate transactions with the same third party. For the three sales, the Company received a total of $8.0 million in cash and issued notes receivable for the remaining $32.0 million. The notes receivable are secured through a first lien deed of trust on the respective properties sold. The notes bear interest at a floating rate of LIBOR plus 4.0% and are capped at 6.0%. Of the three notes, one note in the amount of approximately $4.0 million was paid in full in April 2003. The Company received principal and interest payment of approximately $1.3 million as of December 31, 2003 on the remaining two notes. The two remaining notes have an original maturity date of September 30, 2004. The buyer has the option to extend the maturity date of the notes to September 30, 2005, provided the Company receives notification on or before September 15, 2004 and receives payment of $1.1 million on or before December 31, 2004. If the maturity date is extended, the interest rate on the notes will increase to LIBOR plus 5.0%, not to exceed 7.0% per annum. Subsequent to December 31, 2003, the company received cash in the amount of $7.9 million representing principal and accrued interest outstanding on one of the notes.
Net cash provided by financing activities totaled $149.6 million for the year ended December 31, 2003. During March and April 2003, the Company sold 2,953,310 shares of Series A Mandatory Convertible Preferred Stock (“the preferred shares”). The preferred shares were sold through a private placement to affiliates of HCC (2,453,310 shares) and another investor (500,000 shares). The Company received net proceeds of approximately $34.6 million from this sale, after deducting offering expenses. For the year ended December 31, 2003, dividends of $1.8 million were declared on the preferred shares, of which $0.6 million were accrued and payable at December 31, 2003. The Company subsequently registered these shares.
During the first quarter of 2003, the board of directors suspended the payment of dividends to common shareholders to support the capital needs of the Company. Additionally, under the terms of the preferred stock offering, the Company agreed to suspend dividend payments to common shareholders until April 2005. For the year ended December 31, 2002, quarterly dividends to common shareholders were $0.15 per share, for a total of $0.60 per share.
On May 15, 2003, Argonaut Group Statutory Trust, a Connecticut statutory trust and wholly-owned subsidiary of the Company, sold 15,000 Floating Rate Capital Securities (the “Capital Securities”) (liquidation amount $1,000 per Capital Security) to I-Preferred Term Securities II, Ltd. in a private sale for $15.0 million. The Trust used the proceeds from this sale, together with the proceeds from its sale of 464 shares of Floating Rate Common Securities (liquidation amount $1,000 per Common Security) to the Company, to buy a series of Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Debentures”) due 2033 from the Company. The Debentures have the same payment terms as the Capital Securities.
The interest rate on the Debentures and the Capital Securities is equal to 3-Month LIBOR plus 4.10%, reset quarterly, not to exceed 12.5%. The Debentures are unsecured and are subordinated in right of payment to all of the Company’s future senior indebtedness. Beginning in May 2008, the Company will have the right to redeem the Debentures, in whole or in part, at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption. The Company will also have the right to redeem all of the Debentures before May 2008 upon the happening of specified events at a price equal to 107.5% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption. The Company used $12.0 million of the net proceeds from the sale of the Debentures to increase the statutory capital of its insurance company subsidiaries.
The Company invests excess cash in a variety of investment securities. As of December 31, 2003, the Company’s investment portfolio consisted of 76.7% fixed maturities, 11.0% equities, 0.8% other long-term investments and 11.5% short-term investments, compared to 75.7% fixed maturities, 20.1% equities, 0.8% other long-term investments and 3.4% short-term investments for the same period in 2002. The Company classifies its investment portfolio as available for sale; therefore all investments are reported at fair market value, with unrealized gains and losses being reported as a component of shareholders’ equity. During 2003, the Company re-allocated its investment portfolio, reducing its concentration in equity investments. Due to significant sales, combined with temporary declines in the market value of its investments, shareholders’ equity was reduced by approximately $19.8 million, net of tax, due to the reduction of unrealized gains. As of December 31, 2003, the Company had no investment in any one security that exceeded 10% of shareholders’ equity.
In addition to its investment portfolio, the Company’s subsidiaries own real property for use as home office facilities for Argonaut Insurance Company and Argonaut Great Central, as well as one commercial property in California. These real properties are included in “Other Assets” valued at approximately $1.0 million, which is their original cost less accumulated depreciation. The estimated fair market value of the commercial property is estimated at $12.2 million, based on appraisals completed in November 2001.
The Company entered into a retroactive adverse loss development reinsurance agreement on December 31, 2002 to initially cede $125 million of carried reserves for the workers’ compensation, commercial multiple peril, general liability and asbestos, environmental and other latent losses lines of business. At December 31, 2003, $125.1 million has been recorded as reinsurance funds withheld related to this contract. (Additional information relating to the adverse loss development reinsurance agreement is included under Item 1 “Business - Reinsurance” on pages 8 - 10).
Concerns over terrorist activity have both curtailed the availability of reinsurance for terrorism related risks and increased the cost of obtaining such reinsurance where it is still available. The effect of this industry-wide phenomenon on the Company’s insurance subsidiaries varies by line of business, but reinsurance coverage for terrorist acts involving nuclear, biological and chemical agents is no longer available or cost prohibitive in some instances, thus preventing ceding of these risks through reinsurance. The Company’s insurance subsidiaries have reviewed their accounts for potential exposure to these risks as well as other risks in order to make appropriate decisions on policy exclusions, pricing and renewals, although laws in many states (and particularly those relating to workers’ compensation insurance) place limits on the ability of insurers to effectively limit these risks by contract.
During 2003, the Company contributed capital to Argonaut Insurance Company of $53.4 million. Additionally, the Company restructured Argonaut Insurance Company to concentrate on casualty risk management solutions for upper-middle market accounts. The Company substantially completed this restructuring in the second quarter of 2003, and began to realize improved operating results of this segment in the last six months of 2003. At December 31, 2003, the total adjusted capital of each of the Company’s insurance 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 primarily in the debt securities markets, which exposes it to credit risk. Credit risk is 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, practicing diversification, and frequently monitoring the credit quality of issuers and counterparties.
The Company’s current investment strategy is to invest in callable U.S. Agency securities and minimize exposure to the equity market. Management believes this strategy will result in above average short term yields while protecting the portfolio from rising interest rates. As of December 31, 2003, the investment mix of the pension portfolio was 84% U.S Government agencies, 12% short term investments, and 4% preferred stock. The fair market value of the investment portfolio as of December 31, 2003 was $33.4 million and included net unrealized losses of $2.2 million.
The Company utilizes Fayez Sarofim & Co. to manage a portion of its investment portfolio, for which an investment advisory fee is paid. Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez Sarofim, a member of the Company’s board of directors, is the majority shareholder. Total fees for services paid to Fayez Sarofim & Co. were approximately $0.5 million, $0.5 million and $0.6 million for the years ended December 31, 2003, 2002 and 2001, respectively. The Company believes that this transaction has been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
On March 31, 2003, the Company sold 2,453,310 shares of Series A Mandatory Convertible Preferred Stock (“the preferred shares”) to HCC Insurance Holdings, Inc. (“HCC”). Additionally, 500,000 shares were sold to an unrelated investor. The preferred shares will pay a 7 percent dividend on a quarterly basis. The dividend is cumulative, and is payable when declared by the board of directors. As of December 31, 2003, dividends of $1.8 million were declared, with $0.6 million being accrued and payable as of December 31, 2003.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share reinsurance program with HCC. Under the terms of the agreements, the Company will assume 3.33% of the losses under HCC’s USA Directors and Officers Liability program. Additionally, the Company will assume 5.0% of the losses under HCC’s International Directors and Officers Liability program. As of December 31, 2003, gross written premiums recorded under this program totaled $12.6 million. The Company will pay to HCC ceding and other commissions to offset costs related to these premiums. For the year ended December 31, 2003, the Company expensed ceding and other commissions of $1.3 million.
Subsequent to December 31, 2003, HCC acquired additional shares of the Company’s common stock on the open market, thereby increasing its current ownership percentage (on a fully diluted basis) to 10.33% and is therefore a related party to the Company.
(4) Above table excludes interest credited to funds withheld for adverse development cover agreement. See Item 1, “Business - Reinsurance” on pages 8 - 10 for further discussion.
The Company currently underwrites environmental and pollution coverages (on a limited number of policies) and underground storage tanks. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding company not dissimilar to those results the industry has experienced with regard to asbestos and environmental related claims. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and could have a material adverse effect on the Company’s future financial condition, results of operations and cash flows.
December 31, 2003, the maximum charge to the provision for income taxes will be $62.5 million. If the Company generates sufficient future taxable income to fully utilize the deferred tax asset as of December 31, 2003, the maximum benefit for income taxes will be $76.6 million.