AIHL established Darwin in March 2003 and acquired RSUI in July 2003. On July 1, 2003, AIHL completed the acquisition of Resurgens Specialty which became a subsidiary of RSUI. In connection with the acquisition of Resurgens Specialty, on June 30, 2003, RSUI acquired RIC. On September 2, 2003, RIC purchased Landmark. In 2004, AIHL acquired DNA and in 2005, DNA acquired Darwin Select. We sold Heads & Threads in December 2004. Heads & Threads has been classified as discontinued operations for the two years ended 2004. We sold World Minerals on July 14, 2005. World Minerals has been classified as discontinued operations for the three years ended 2005. On July 18, 2007, AIHL acquired EDC.
Our insurance operating units provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and as a result, these claims can have a very long claim tail, occasionally extending for decades. In conformity with GAAP, our insurance operating units are not permitted to establish IBNR reserves for catastrophe losses that have not occurred. Therefore, losses related to a significant catastrophe or accumulation of catastrophes in any reporting period could have a material, negative impact on our results during that period. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long-tail casualty lines of business, estimation of ultimate liabilities for unpaid losses and loss adjustment expenses is a more complex process and depends on a number of factors, including the line and volume of the business involved. For these reasons, AIHL’s insurance operating units will generally use actuarial projections in setting reserves for all casualty lines of business.
Although we are unable at this time to determine whether additional reserves, which could have a material impact upon our financial condition, results of operations and cash flows, may be necessary in the future, we believe that the reserves for unpaid losses and loss adjustment expenses established by our insurance operating units are adequate as of December 31, 2007.
Methodologies and Assumptions. Our insurance operating units use a variety of techniques that employ significant judgments and assumptions to establish the liabilities for unpaid losses and loss adjustment expenses recorded at the balance sheet date. These techniques include detailed statistical analyses of past claim reporting, settlement activity, claim frequency, internal loss experience, changes in pricing or coverages and severity data when sufficient information exists to lend statistical credibility to the analysis. More subjective techniques are used when statistical data is insufficient or unavailable. These liabilities also reflect implicit or explicit assumptions regarding the potential effects of future inflation, judicial decisions, changes in laws and recent trends in such factors as well as a number of actuarial assumptions that vary across our insurance operating units and across lines of business. This data is analyzed by line of business, coverage and accident year, as appropriate.
Bornhuetter-Ferguson Method: the results from the Expected Loss Ratio method are essentially blended with either the Reported Loss Development method or the Paid Development method.
Each of these actuarial methods uses underlying assumptions that vary by insurance operating unit and line of business and produce point estimates for each class of business. The primary assumptions used by our insurance operating units include the following:
Expected loss ratios: represent management’s expectation of losses, in relation to earned premium, at the time business is written, before any actual claims experience has emerged. This expectation is a significant determinant of the estimate of loss reserves for recently written business where there is little paid or incurred loss data to consider. Expected loss ratios are generally derived from historical loss ratios adjusted for the impact of rate increases, loss cost trends and known changes in the type of risks underwritten.
Rate of loss cost inflation: represents management’s expectation of the inflation associated with the costs it will incur in the future to settle claims. Expected loss cost inflation is particularly important for claims with a substantial medical component, such as workers’ compensation.
Sensitivity. 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 insurance operating units. The length of the loss reporting lag affects our 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 estimate. 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 estimate for claims occurring in 2007 (dollars in thousands):
Our net reserves for losses and loss adjustment expenses of $1.7 billion as of December 31, 2007 relate to multiple accident years. Therefore, the impact of changes in frequency or severity for more than one accident year could be higher or lower than the amounts reflected above. We believe the above analysis
provides a reasonable benchmark for sensitivity, as we believe it is within historical variation for our reserves, and currently, none of the scenarios is believed to be more likely than the other.
During 2007, RSUI increased its prior year reserves by $8.5 million, primarily reflecting a net increase in estimated losses and loss adjustment expenses related primarily to Hurricane Katrina in the amount of $43.2 million after reinsurance, partially offset by an aggregate net release of $34.7 million of prior year reserves principally for the professional liability and D&O liability lines of business. The increase in Hurricane Katrina reserves primarily reflect the results of reviews, completed during 2007, of Katrina loss and loss adjustment expense reserves in light of the current uncertain legal environment. RSUI reviews its reserves quarterly. In 2007, settlements of pending claims were larger than expected, which contributed to RSUI’s decision to increase reserves for its remaining pending Hurricane Katrina claims. The release of prior year reserves principally for the professional liability and D&O liability lines of business primarily reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. Such reduction did not impact the assumptions used in estimating RSUI’s loss and loss adjustment expense liabilities for business earned in 2007.
During 2007, CATA had a net release of $14.4 million of prior year reserves, primarily in its liability and commercial surety lines of business. The reduction reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. Such reduction did not impact the assumptions used in estimating CATA’s loss and loss adjustment expense liabilities for business earned in 2007. During 2006, CATA had a net release of $13.6 million of prior year reserves, primarily in its commercial surety, contract surety and commercial multiple peril lines of business. The reduction reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business.
During 2007, EDC had a net reserve release of workers’ compensation reserves of $9.7 million. This release consisted of an $18.8 million decrease for prior accident years, partially offset by a $9.1 million increase for the 2007 accident year through the date of the acquisition by AIHL. EDC’s reduction of prior year reserves reflects favorable loss emergence as compared with loss emergence patterns assumed in earlier periods for such line of business. The increase in reserves for the 2007 accident year through the date of acquisition reflects unfavorable loss emergence patterns, compared with loss emergence patterns assumed in the period prior to AIHL’s acquisition.
Asbestos & Environmental. Our reserve for unpaid losses and loss adjustment expenses includes $22.9 million and $22.7 million of gross and net reserves, respectively, at December 31, 2007, for various liability coverages related to asbestos and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976. The subsidiary exited this business in 1976. Reserves for asbestos and environmental impairment claims cannot be estimated with traditional loss reserving techniques because of uncertainties that are greater than those associated with other types of claims. Factors contributing to these uncertainties include a lack of historical data, the significant periods of time that often elapse between the occurrence of an insured loss and the reporting of that loss to the ceding company and the reinsurer, uncertainty as to the number and identity of insureds with potential exposure to these risks, unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Loss reserve estimates for these environmental impairment and asbestos exposures include case reserves, which also reflect reserves for legal and other loss adjustment expenses and IBNR reserves. IBNR reserves are determined based upon CATA’s historic general liability exposure base and policy language, previous environmental impairment loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.
Reinsurance. Receivables recorded with respect to claims ceded by our insurance operating units 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 receivables may prove uncollectible if the reinsurer is unable to perform under the contract. Reinsurance contracts purchased by our insurance operating units do not relieve them of their obligations to
their own policyholders. Additional information regarding the use of, and risks related to, the use of reinsurance by our insurance operating units can be found on pages 26 and 27 of this Form 10-K Report.
extraordinary events, including negative news releases and rating agency downgrades, with respect to the issuer of an investment; and
Our consolidated balance sheet as of December 31, 2007 includes goodwill and other intangible assets, net of amortization, of approximately $215.0 million. This amount has been recorded as a result of business acquisitions. Goodwill and other intangible assets are tested annually for impairment. We completed the annual test for impairment during the fourth quarter of 2007 based upon results of operations through September 30, 2007 and determined that there was no indication of impairment. A significant amount of judgment is required in performing goodwill and other intangible assets impairment tests. These tests include estimating the fair value of our operating units and other intangible assets. With respect to goodwill, as required by Financial Accounting Standards Board Statement No. 142, or “SFAS 142,” we compare the estimated fair value of our operating units with their respective carrying amounts including goodwill. Under SFAS 142, fair value refers to the amount for which the entire operating unit may be bought or sold. Our methods for estimating operating unit 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.
We file a consolidated federal income tax return with our subsidiaries, except for Darwin as a result of its initial public offering in May 2006. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. At
December 31, 2007, a net deferred tax liability of $57.7 million was recorded, which included a valuation allowance of $13.9 million for certain deferred state tax assets which we believe may not be realized. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. This determination is based upon a review of anticipated future earnings as well as all available evidence, both positive and negative.
We are engaged, through AIHL and its subsidiaries, primarily in the property and casualty and surety insurance business. In addition, AIHL Re, a captive reinsurance subsidiary of AIHL, is available to provide reinsurance to our insurance operating units and affiliates. We also own and manage properties in the Sacramento, California region through our subsidiary Alleghany Properties and conduct corporate investment and other activities at the parent level, including the holding of strategic equity investments. Our primary sources of revenues and earnings are our insurance operations and investments.
With respect to reinsurance, as part of their overall risk and capacity management strategy, our insurance operating units purchase reinsurance for certain amounts of risk underwritten by them, especially catastrophe risks. The reinsurance programs purchased by our insurance operating units are generally subject to annual renewal. Market conditions beyond their control determine the availability and cost of the reinsurance protection they purchase, which may affect the level of businesses written and thus their profitability.
Catastrophe losses, or the absence thereof, have also had a significant impact on our results. For example, pre-tax catastrophe losses, net of reinsurance and reinsurance reinstatement premiums, at our insurance operating units were $48.9 million in 2007, $18.0 million in 2006 and $330.8 million in 2005. The incidence and severity of catastrophes in any short period of time are inherently unpredictable. Catastrophes can cause losses in a variety of our property and casualty lines, and most of our past catastrophe-related claims have resulted from severe storms. Although we experienced minimal catastrophe losses in 2007 and 2006, it is possible that a catastrophic event or multiple catastrophic events could produce significant losses and have a material adverse effect on our financial condition and results of operations in the future.
Amount reflects the discontinued operations of World Minerals prior to its sale in July 2005.
Our earnings before income taxes and minority interest in 2007 increased from 2006, reflecting increases in net premiums earned and substantially higher net realized capital gains, partially offset by an increase in loss and loss adjustment expenses and commissions, brokerage and other underwriting expenses. The increase in net premiums earned primarily reflects growth at RSUI, CATA and Darwin, and the inclusion of the results of EDC commencing in July 2007. The increase in net realized capital gains in 2007 primarily reflects the sale in 2007 of approximately 809,000 shares of common stock of Burlington Northern for a net realized capital gain of $55.9 million, as well as the sale of common stock holdings in the energy sector for a net realized capital gain of $28.5 million. The decrease in other income for 2007 reflects gains on sales of real property by Alleghany Properties of $14.7 million during 2007, compared with gains of $24.3 million in 2006.
The increase in loss and loss adjustment expenses and commissions, brokerage and other underwriting expenses primarily reflects the growth in net premiums earned at RSUI, CATA and Darwin, and the inclusion of the results of EDC commencing in July 2007. Other operating expenses increased in 2007 from 2006, primarily reflecting increased long-term incentive expense accruals at our insurance operating units. Interest expense decreased in 2007 from 2006, primarily reflecting the maturity of our $80.0 million of floating rate notes in January of 2007 of our financing subsidiary Alleghany Funding Corporation, or “Alleghany Funding.”
Our earnings from continuing operations before income taxes and minority interest in 2006 increased from 2005, primarily reflecting a significant decrease in net catastrophe losses incurred in 2006 compared with 2005, which included significant catastrophe losses attributable to Hurricanes Katrina and Rita. Pre-tax catastrophe losses were $18.0 million in 2006, compared with $330.8 million, including reinsurance reinstatement premiums, in 2005. 2006 results also reflect an increase in net premiums earned and net investment income, partially offset by lower net realized capital gains, higher non-catastrophe-related loss and loss adjustment expenses related to the increase in net premiums earned, and higher other income. The increase in net premiums earned in 2006 from 2005 primarily reflects growth at each of our insurance operating units. The increase in net investment income in 2006 from 2005 primarily reflects strong underwriting cash flow. The decrease in net realized capital gains in 2006 from 2005 primarily reflects $132.6 million of capital gains due to the sale of common stock of Burlington Northern and CIGNA in 2005. The increase in other income in 2006 from 2005 primarily reflects a $23.1 million gain on sale of 59 acres of real estate in May 2006 by Alleghany Properties.
The effective tax rate on earnings from continuing operations before income taxes was 33 percent in 2007, 29 percent in 2006, and 23 percent in 2005. The effective tax rate in 2007 reflects a net tax adjustment of $5.2 million in the fourth quarter of 2007 resulting primarily from the reduction of estimated deferred tax assets related to unused foreign tax credits. The unused foreign tax credits arose from our ownership of World Minerals prior to its sale in July 2005. The effective tax rate in 2006 reflects a tax benefit of $10.8 million in the first quarter of 2006 resulting from the release of a valuation allowance we held with respect to a portion of our deferred tax assets related to such unused foreign tax credits. The lower effective tax rate in 2005 relative to both 2007 and 2006 reflects the impact of significant catastrophe losses incurred during 2005.
Represents net premiums earned less loss and loss adjustment expenses and underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income and other income or net realized capital gains. Underwriting profit does not replace net income determined in accordance with GAAP as a measure of profitability; rather, we believe that underwriting profit, which does not include net investment income and other income or net realized capital gains, enhances the understanding of AIHL’s insurance operating units’ operating results by highlighting net income attributable to their underwriting performance. With the addition of net investment income and other income and net realized capital gains, reported pre-tax net income (a GAAP measure) may show a profit despite an underlying underwriting loss. Where underwriting losses persist over extended periods, an insurance company’s ability to continue as an ongoing concern may be at risk. Therefore, we view underwriting profit as an important measure in the overall evaluation of performance.
The slight decrease in loss and loss adjustment expenses in 2007 from 2006 primarily reflects continued favorable current accident year loss experience for property and to a lesser extent, D&O lines of business, partially offset by an $8.5 million net increase in reserves. This net reserve increase reflects a $43.2 million increase in estimated losses and loss adjustment expenses related to Hurricane Katrina, partially offset by a release of $34.7 million of prior year reserves principally for the professional liability and D&O lines of business. The increase in Hurricane Katrina reserves primarily reflect the results of reviews, completed during 2007, of Katrina loss and loss adjustment expense reserves in light of the current uncertain legal environment. RSUI reviews its reserves quarterly. In 2007, settlements of pending claims were larger than expected, which contributed to RSUI’s decision to increase reserves for its remaining pending Hurricane Katrina claims. Future
legal developments, to the extent adverse to the insurance industry, may result in additional adverse development in RSUI’s Hurricane Katrina loss and loss adjustment expense reserves. The release of prior year reserves for the professional liability and D&O liability lines of business reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. The significant decrease in loss and loss adjustment expenses in 2006 from 2005 primarily reflects the absence in 2006 of significant catastrophe losses, compared with significant catastrophe losses in 2005.
Rates at RSUI in 2007 compared to 2006 reflect overall industry trends of downward pricing as a result of increased competition, with decreased rates in all of RSUI’s lines of business, particularly with respect to the general liability, umbrella and property lines of business. In 2006, rates for RSUI’s catastrophe-exposed property risks increased substantially, more than offsetting reductions in premium resulting from exposure reduction efforts RSUI commenced during the 2005 fourth quarter. RSUI undertook such efforts to reduce its exposed limits and raise attachment points on catastrophe-exposed property business. RSUI believes that its efforts have resulted in significantly lower accumulations of catastrophe risk on a gross basis. With respect to RSUI’s casualty lines of business, rates during 2006 decreased slightly from 2005 due to increased competition.
AIHL Re’s underwriting profit in 2007 reflects the absence of catastrophe losses during the period. In connection with the expiration of the reinsurance agreement, the trust funds established to secure AIHL Re’s obligations to make payments to RSUI under such reinsurance agreement were dissolved and the $208.0 million in such trust funds was returned to AIHL.
The increases in CATA’s net premiums earned in 2007 from 2006, and in 2006 from 2005, reflect growth in gross and net premiums written in CATA’s property and casualty (including in excess and surplus markets) lines of business. The increases in loss and loss adjustment expenses in 2007 from 2006, and in 2006 from 2005, reflect growth in net premiums earned and higher property losses, partially offset by reductions of prior year reserves principally related to liability and commercial surety lines of business. Such reductions were $14.4 million in 2007, $13.6 million in 2006 and $5.1 million in 2005. The increase in underwriting expenses in 2007 from 2006, and in 2006 from 2005, primarily reflect higher commissions and other acquisition-related expenses as a consequence of increased premium volumes. The increases in CATA’s underwriting profit in 2007 from 2006, and in 2006 from 2005, primarily reflect favorable loss emergence principally in its liability and commercial surety lines of business, resulting in a release of prior year reserves, partially offset by higher than expected current year property loss frequency and severity. CATA’s property lines of business were unprofitable in 2007.
Additional information regarding CATA’s releases of prior year reserves can be found on page 35 of this Form 10-K Report.
EDC’s net premiums earned in 2007 reflect rate decreases on new and renewal policies of 9.5 percent effective December 15, 2006 and 14.2 percent effective June 30, 2007. Loss and loss adjustment expenses in 2007 reflect the exposure of EDC’s underlying book of business, relatively flat trends in loss costs and the favorable impact of a net $9.7 million reduction in reserves for periods prior to EDC’s acquisition by AIHL. This $9.7 million reserve reduction consisted of an $18.8 million reduction in reserves for prior accident years, partially offset by a $9.1 million increase for the 2007 accident year through the date of EDC’s acquisition by AIHL. Additional information regarding EDC’s releases to prior year reserves can be found on page 36 of this Form 10-K Report. EDC experienced increased competition and decreasing rates in its California workers’ compensation business during 2007.
AIHL’s results include the results of EDC, net of purchase accounting adjustments, commencing July 18, 2007. See Note 16 to the Notes to our consolidated financial statements set forth in Item 8 of this Form 10-K Report.
Additional information regarding Darwin’s use of reinsurance and risks related to reinsurance recoverables can be found on page 20 and page 26 of this Form 10-K Report. Additional information regarding Darwin’s releases of prior year reserves can be found on pages 35 and 36 and page 46 of this Form 10-K Report.
Darwin experienced increased competition and decreased rates across all of its lines of business during 2007, compared with 2006.
guarantees. The loss and loss adjustment expense reserves are ceded 100 percent to the sellers. Additional information regarding the loss reserve guarantees can be found in Note 5 to the Notes to our consolidated financial statements contained in Item 8 of this Form 10-K Report.
Gross Reserves. The increase in gross loss and loss adjustment expense reserves at December 31, 2007 from December 31, 2006 primarily reflects increases in workers’ compensation and casualty gross loss and loss adjustment expense reserves, partially offset by a net reduction in RSUI’s property gross loss and loss adjustment expense reserves. The increase in workers’ compensation gross loss and loss adjustment expense reserves is due to the acquisition of EDC. The increase in casualty gross loss and loss adjustment expense reserves primarily reflects anticipated loss reserves on current accident year gross premiums earned and limited gross paid loss activity for the current and prior casualty accident years at RSUI and Darwin, partially offset by releases of prior year reserves. The decrease in property gross loss and loss adjustment expense reserves is mainly due to gross loss payments on 2004 and 2005 hurricane related losses, principally Hurricane Katrina.
Net Reserves. The increase in net loss and loss adjustment expense reserves at December 31, 2007 from December 31, 2006 primarily reflects increases in workers’ compensation and casualty net loss and loss adjustment expense reserves. The increase in workers’ compensation gross loss and loss adjustment expense reserves is due to the acquisition of EDC. The increase in casualty gross loss and loss adjustment expense reserves is due to RSUI and Darwin, and primarily reflects anticipated loss reserves on current accident year gross premiums earned and limited gross paid loss activity for the current and prior casualty accident years, and lower reinsurance utilization, partially offset by releases of prior year reserves. Slightly lower loss and loss adjustment expense property reserves is mainly due to loss payments on 2004 and 2005 hurricane related losses, principally Hurricane Katrina, partially offset by an increase in estimated losses, net of reinsurance recoverables on unpaid losses, related to Hurricane Katrina, as discussed in more detail on pages 42 and 43 of this Form 10-K Report.
At December 31, 2007, AIHL had total reinsurance recoverables of $1.0 billion, consisting of $0.9 billion of ceded outstanding losses and loss adjustment expenses and $0.1 billion of recoverables on paid losses. AIHL’s largest concentration of reinsurance recoverables at December 31, 2007 was $182.6 million,
AIHL’s 2007 net realized capital gains primarily reflect the sale of common stock holdings primarily in the energy and mining sectors. AIHL’s 2006 net realized capital gains primarily reflect the sale of common stock holdings in the energy sector. AIHL’s 2005 net realized capital gains primarily reflect the sale of 404,000 shares of CIGNA, for aggregate cash proceeds of $33.0 million.
AIHL’s debt securities portfolio has been designed to enable management to react to investment opportunities created by changing interest rates, prepayments, tax and credit considerations or other factors, or to circumstances that could result in a mismatch between the desired duration of portfolio assets and the duration of liabilities, and, as such, is classified as available for sale.
In the event paid losses accelerate beyond the ability of AIHL’s insurance operating units to fund these paid losses from current cash balances, current operating cash flow, coupon receipts and security maturities, AIHL would need to liquidate a portion of its investment portfolio, receive capital contributions from us and/or arrange for financing. Strains on liquidity could result from the occurrence of several significant catastrophic events in a relatively short period of time, the sale of investments to fund these paid losses into a depressed marketplace, the uncollectibility of reinsurance recoverables on these paid losses, the significant decrease in the value of collateral supporting these reinsurance recoverables or a significant reduction in our net premium collections. Although the majority of AIHL’s investment holdings are denominated in U.S. dollars, investments may be made in other currency denominations depending upon investment opportunities in those currencies, or as may be required by regulation or law. AIHL’s investment guidelines require compliance with applicable local regulations and laws.
Investment Position Summary. The following table summarizes the investments of AIHL and its subsidiaries on a consolidated basis, excluding cash, as of December 31, 2007 and 2006, with all investments carried at fair value (in thousands, except for percentages):
At December 31, 2007, AIHL’s mortgage- and asset-backed securities portfolio was backed by the following types of underlying collateral (in thousands):
“GNMA” refers to the Government National Mortgage Association; “FNMA” refers to the Federal National Mortgage Association; and “FHLMC” refers to the Federal Home Loan Mortgage Corporation.
Approximately 28.3 percent, or approximately $820.7 million, of AIHL’s debt securities, predominantly municipal obligations, are insured by financial guaranty insurance companies. This insurance increases the credit quality and credit ratings of the debt securities discussed above. If the obligations of these financial guarantors ceased to be valuable due to either a credit rating downgrade or default, these debt securities would likely receive lower credit ratings by the rating agencies that would reflect the stand-alone creditworthiness of the various underlying obligors as if the debt securities were uninsured. The following table summarizes the credit quality of AIHL’s portfolio as currently rated, and the credit quality as if the securities in AIHL’s portfolio were uninsured:
The following tables summarize, for all securities in an unrealized loss position at December 31, 2007 and 2006, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (in thousands):
Debt Securities Portfolio. The following table reflects investment results for the debt securities portfolio of AIHL and its subsidiaries, on a consolidated basis, for the years ended December 31, 2007, 2006 and 2005 (in thousands, except for percentages):
Net pre-tax net investment income for the period divided by average investments for the same period.
We hold certain strategic investments at the parent level. In this regard, as of December 31, 2007, we owned approximately 5.0 million shares of Burlington Northern. Burlington Northern owns one of the largest railroad networks in North America. These shares had an aggregate market value on December 31, 2007 of approximately $416.2 million, or $83.23 per share. The aggregate cost of our Burlington Northern common stock is approximately $60.4 million, or $12.07 per share. In February 2008, we sold approximately 431,000 shares of our Burlington Northern stock holdings for proceeds of approximately $38.9 million.
General. In recent years, we have followed a policy of maintaining a relatively liquid financial condition at the parent company in the form of cash, marketable securities, available credit lines and minimal amounts of debt. This policy has permitted us to expand our operations through internal growth at our subsidiaries and through acquisitions of, or substantial investments in, operating companies. At December 31, 2007, we held approximately $556.5 million of marketable securities and cash at the parent company. We had no material commitments for capital expenditures at December 31, 2007.
On May 24, 2006, Darwin closed the initial public offering of its common stock. In the offering, Darwin sold 6.0 million shares of common stock for net proceeds of $86.3 million, all of which were used to reduce our equity interests in Darwin by redeeming Darwin preferred stock held by us. Upon completion of the offering, all remaining unredeemed shares of Darwin preferred stock automatically converted to shares of Darwin common stock. We continue to own approximately 55 percent of the total outstanding shares of common stock of Darwin, with no preferred stock outstanding. In connection with this transaction, we recorded an after-tax gain of $9.5 million, which is reflected in “Contributed capital.” The third-party ownership of Darwin is reflected on our consolidated balance sheet and income statement as a minority interest liability and as an expense.
On June 23, 2006, we completed an offering of 1,132,000 shares of 5.75% mandatory convertible preferred stock, or the “Preferred Stock,” at a public offering price of $264.60 per share, resulting in net proceeds of $290.4 million. The annual dividend on each share of Preferred Stock is $15.2144. Dividends on the Preferred Stock accrue and accumulate from the date of issuance, and, to the extent we are legally permitted to pay dividends and our Board of Directors declares a dividend payable, we will pay dividends in cash on a quarterly basis. Each share of Preferred Stock has a liquidation preference of $264.60, plus any accrued, cumulated and unpaid dividends. Each share of Preferred Stock will automatically convert on June 15, 2009 into between 0.8475 and 1.0000 shares of our common stock depending on the average market price per share of our common stock over the 20 trading day period ending on the third trading day prior to such date. The conversion rate is also subject to anti-dilution adjustments. At any time prior to June 15, 2009, holders of the Preferred Stock may elect to convert each share of Preferred Stock into 0.8475 shares of our common stock, subject to anti-dilution adjustments. All of the above per share data has not been adjusted for subsequent Alleghany common stock dividends.
Stockholders’ equity increased to $2,793.9 million as of December 31, 2007, compared with $2,449.3 million as of December 31, 2006, representing an increase of 14.1 percent, due primarily to an increase in our 2007 consolidated net income. In addition, stockholders’ equity benefited from an increase in net unrealized appreciation in our equity and fixed income portfolios. Stockholders’ equity increased to $2,449.3 million as of December 31, 2006, compared with $1,894.4 million as of December 31, 2005, representing an increase of 29.3 percent. The increase is due to the Preferred Stock issuance and the gain that we recorded as a result of Darwin’s initial public offering of common stock, as well as an increase in our consolidated net income for 2006. In addition, stockholders’ equity increased modestly from net unrealized appreciation in our equity portfolio, primarily due to our holdings of Burlington Northern common stock.
Credit Agreement. In addition to our liquid assets, on October 23, 2006, we entered into a three-year unsecured credit agreement, or the “Credit Agreement,” with a bank syndicate, providing commitments for revolving credit loans in an aggregate principal amount of up to $200.0 million. Borrowings under the Credit Agreement will be available for working capital and general corporate purposes. At our option, borrowings under the Credit Agreement will bear interest at either (x) the higher of (i) the administrative agent’s prime commercial lending rate or (ii) the federal funds rate plus 0.5 percent, or (y) the London Interbank Overnight Rate, or “LIBOR,” plus a margin (currently 50 basis points) based on our Standard & Poors’ and/or Moody’s rating. The Credit Agreement requires that all loans shall be repaid in full no later than the Maturity Date, or October 23, 2009, although we may request up to two one-year extensions of the Maturity Date subject to meeting certain conditions and upon agreement of the Lenders. The Credit Agreement charges us a commitment fee of 1/8th of 1 percent per annum of the unused commitment.
Under the Credit Agreement, an Event of Default is defined as (a) a failure to pay any principal or interest on any of the Loans or other Obligations under the Credit Agreement within designated time periods; (b) a breach of any representation or warranty made in the Credit Agreement; (c) a failure to comply with certain specified covenants, conditions or agreements; (d) a failure to comply with any other conditions, covenants or agreements within 15 days after knowledge or written notice of such failure; (e) the occurrence of certain bankruptcy, insolvency or reorganization events; (f) the occurrence of certain money judgments in excess of $5.0 million; (g) the acceleration of the maturity of any indebtedness of Alleghany or any subsidiary in an amount exceeding $5.0 million, or “Material Indebtedness,” or failure by Alleghany or any subsidiary to pay any Material Indebtedness when due or payable, or the failure by Alleghany or any subsidiary to comply with conditions, covenants or agreements in any agreement or instrument relating to Material Indebtedness which causes, or permits the holder of such Material Indebtedness to cause, the acceleration of such indebtedness; (h) the occurrence of certain events constituting a Change of Control of Alleghany; or (i) the issuance of any orders of conservation or supervision in respect of any material insurance subsidiary. If an Event of Default occurs, then, to the extent permitted in the Credit Agreement, the Lenders may terminate the Commitments, accelerate the repayment of any outstanding loans and exercise all rights and remedies available to such Lenders under the Credit Agreement and applicable law.
The Credit Agreement replaced a three-year unsecured credit agreement with a bank syndicate which was scheduled to expire by its terms on July 27, 2007, or the “Prior Credit Agreement,” and which also provided commitments for revolving credit loans in an aggregate principal amount of up to $200.0 million. No amounts
Capital Contributions. From time to time, we make capital contributions to our subsidiaries when third-party financing may not be attractive or available. In 2007, we made a capital contribution of $50.0 million to AIHL to provide additional capital support to EDC in connection with AIHL’s acquisition of EDC. In 2006, we made a capital contribution of $100.0 million to AIHL to provide catastrophe reinsurance coverage for RSUI through AIHL Re, a captive reinsurance subsidiary of AIHL. In addition, in 2006 we made a capital contribution of $88.0 million to AIHL in connection with its investment in Homesite. In 2005, we made capital contributions of $150.8 million to AIHL to provide additional capital to RSUI as a result of the 2005 hurricanes and $135.0 million to AIHL to provide additional capital to Darwin to support its business expansion and transition to a stand-alone insurance underwriting group. We expect that we will continue to make capital contributions to our subsidiaries in the future for similar or other purposes.
Other long-term liabilities primarily reflect employee pension, certain retired executive pension obligations and certain incentive compensation plans.
Our insurance operating units have obligations to make certain payments for losses and adjustment expenses pursuant to insurance policies they issue. These future payments are reflected as reserves on our consolidated financial statements. With respect to loss and loss adjustment expenses, there is typically no minimum contractual commitment associated with insurance contracts and the timing and ultimate amount of actual claims related to these reserves is uncertain. Additional information regarding reserves for loss and loss adjustment expenses, including information regarding the timing of payments of these expenses, can be found on pages 14 through 18, page 24, pages 32 through 36 and pages 45 and 46 of this Form 10-K Report.
Material Off-Balance Sheet Arrangements. We did not enter into any off-balance sheet arrangements during 2007, 2006 or 2005, nor did we have any off-balance sheet arrangements outstanding at December 31, 2007, 2006 or 2005.
AIHL. The obligations and cash outflow of AIHL’s insurance operating units include claim settlements, administrative expenses and purchases of investments. In addition to premium collections, cash inflow is obtained from interest and dividend income and maturities and sales of investments. Because cash inflow from premiums is received in advance of cash outflow required to settle claims, AIHL’s insurance operating units accumulate funds which they invest pending the need for liquidity. As an insurance company’s cash needs can be unpredictable due to the uncertainty of the claims settlement process, AIHL’s portfolio, which includes those of its insurance operating units, is composed primarily of debt securities and short-term investments to ensure the availability of funds and maintain a sufficient amount of liquid securities. As of December 31, 2007, investments and cash represented 69.8 percent of the assets of AIHL and its insurance operating units.
primarily of high quality debt securities with an average life of 5.93 years and an effective duration of 4.31 years. Effective duration measures a portfolio’s sensitivity to change in interest rates; a change within a range of plus or minus 1 percent in interest rates would be expected to result in an inverse change of approximately 4 percent in the fair market value of the portfolio of AIHL. The overall debt securities portfolio credit quality is measured using the lower of either Standard & Poor’s or Moody’s rating. The weighted average rating at December 31, 2007 was AAA, with all securities rated investment grade. Additional information regarding AIHL’s investment portfolio and the credit quality of AIHL’s debt securities portfolio can be found on page 49 of this Form 10-K Report.
Additional information regarding the use of, and risks related to, reinsurance by our insurance operating units, which may impact their financial position, results of operations and cash flows can be found on pages 18 through 21, pages 26 and 27 and pages 42 through the top of page 45 of this Form 10-K Report.
tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. We have adopted the provisions of this Interpretation as of January 1, 2007, and the implementation did not have any material impact on our results of operations and financial condition.
In September 2006, FASB Statement No. 157, “Fair Value Measurements,” was issued. This Statement provides guidance for using fair value to measure assets and liabilities. The Statement does not expand the use of fair value in any new circumstances. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We have adopted the provisions of this Statement as of January 1, 2008, and the implementation did not have any material impact on our results of operations and financial condition.
In September 2006, FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R),” or “SFAS 158,” was issued. We adopted SFAS 158 as of December 31, 2006. Refer to Note 11 of the Notes to the consolidated financial statements set forth in Item 8 of this Form 10-K Report.
At its September 2006 meeting, the Emerging Issues Task Force reached a consensus with respect to Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This Issue addresses split-dollar life insurance, which is defined as an arrangement in which the employer and an employee share the cash surrender value and/or death benefits of the insurance policy. Premiums may either be split by the employer and the employee, or the employer pays all of the premiums. This Issue applies to endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods. In such instances, an employer should recognize a liability for future benefits in accordance with FASB Statement No. 106 or FASB Opinion No. 12 (depending on whether a substantive plan is deemed to exist) based on the substantive agreement with the employee. This Issue is effective for fiscal years beginning after December 15, 2007. We have endorsement split-dollar life insurance policies for our executives that are effective during employment as well as retirement. Premiums are paid by us, and death benefits are split between us and the beneficiaries of the executive. Death benefits after retirement that inure to the beneficiaries are generally equal to the annual ending salary of the executive at the date of retirement. We have adopted the provisions of this Issue as of January 1, 2008, and the implementation did not have any material impact on our results of operations and financial condition.
The Securities and Exchange Commission released Staff Accounting Bulletin No. 108 (“SAB 108”), in September 2006. SAB 108 provides guidance on how the effects of the carryover or reversal of prior year financial statement misstatements should be considered in quantifying a current period misstatement. In addition, upon adoption, SAB 108 permits an entity to adjust for the cumulative effect of immaterial errors relating to prior years in the carrying amount of assets and liabilities as of the beginning of the current fiscal year, with an offsetting adjustment to the opening balance of retained earnings. SAB 108 also requires the adjustment of any prior quarterly financial statements within the fiscal year of adoption for the effects of such errors on the quarters when the information is next presented. We have adopted the provisions of SAB 108 as of January 1, 2007, and the implementation did not have any material impact on our results of operations and financial condition.
In February 2007, FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115,” was issued. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value, at specified election dates, with unrealized gains and losses reported in earnings at each subsequent reporting date. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, “Fair Value Measurements.” We have adopted the provisions of this Statement as of January 1, 2008, and the implementation did not have any effect on our results of operations and financial condition.
In December 2007, FASB Statements No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”), and No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”) were issued. SFAS 141R replaces FASB Statement No. 141, “Business Combinations.” SFAS 141R requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose additional information regarding the nature and financial effect of the business combination. SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries in the same way - as equity in the consolidated financial statements. SFAS 160 also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. We will adopt SFAS 141R and SFAS 160 for all business combinations initiated after December 31, 2008. We will also reclassify our minority interest liabilities as a separate component of shareholders’ equity after December 31, 2008.
Alleghany Corporation, a Delaware corporation, which together with its subsidiaries is referred to as “Alleghany” unless the context otherwise requires, is engaged in the property and casualty and surety insurance business through its wholly-owned subsidiary Alleghany Insurance Holdings LLC (“AIHL”). AIHL’s insurance business is conducted through its wholly-owned subsidiaries RSUI Group, Inc. (“RSUI”), Capitol Transamerica Corporation and Platte River Insurance Company (“Platte River”), (collectively, “CATA” unless the context otherwise requires), Employers Direct Corporation (“EDC”) and AIHL’s majority-owned subsidiary, Darwin Professional Underwriters, Inc. (“Darwin”). In addition, AIHL Re LLC (“AIHL Re”), a captive reinsurance subsidiary of AIHL, is available to provide reinsurance to Alleghany insurance operating units and affiliates. Alleghany also owns and manages properties in the Sacramento, California region through its subsidiary Alleghany Properties Holdings LLC (“Alleghany Properties”). On December 29, 2006, Alleghany, through its subsidiary AIHL, acquired a 32.9 percent ownership in Homesite Group Incorporated (“Homesite”), a national, full-service, mono-line provider of homeowners insurance.
investments include commercial paper, certificates of deposit, money market instruments and any fixed maturity with an initial maturity of one year or less.
At December 31, 2007 and 2006, available-for-sale securities are recorded at fair value.
Alleghany entered into an interest rate swap for purposes of matching interest expense with interest income. The interest rate swap was accounted for as a hedge of the obligation. Interest expense was recorded using the revised interest rate. The interest rate swap matured in January 2007 at no gain or loss to Alleghany.
Premiums are recognized as revenue on a pro-rata basis over the term of an insurance policy. This recognition method is based on the short-term (twelve months or less) nature of the lines of business written by AIHL’s insurance operating units, which consist of property and casualty and surety lines. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of insurance policies in force.
Reinsurance recoverables (including amounts related to claims incurred but not yet reported (“IBNR”)) and prepaid reinsurance premiums are reported as assets. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. Ceded premiums are charged to income over the applicable terms of the various reinsurance contracts with third-party reinsurers.
Property and equipment is recorded at cost, net of accumulated depreciation and amortization. Depreciation of buildings and equipment and amortization of leasehold improvements are principally calculated using the straight-line method over the estimated useful life of the respective assets or the life of the lease, whichever is less. Rental expense on operating leases is recorded on a straight-line basis over the term of the lease, regardless of the timing of actual lease payments.
Alleghany files a consolidated federal income tax return with its subsidiaries, except for Darwin which, subsequent to the closing of its initial public offering on May 24, 2006, files its own federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The reserves for losses and loss adjustment expenses represent management’s best estimate of the ultimate cost of all reported and unreported losses incurred through the balance sheet date and include, but are not limited to: (i) the accumulation of individual estimates for claims reported on direct business prior to the close of an accounting period; (ii) estimates received from reinsurers with respect to reported claims which have been reinsured; (iii) estimates for IBNR based on past experience modified for current trends and industry data and (iv) estimates of expenses for investigating and settling claims based on past experience. The reserves recorded are based on estimates resulting from the review process, and differences between estimates and ultimate payments are reflected as an expense in the statement of earnings in the period in which the estimates are revised.
Revenue and profits from land sales are recognized using the full accrual method when title has passed to the buyer, the collectibility of the sales price is reasonably assured, the required minimum cash down payment has been received and Alleghany has no continuing involvement with the property. Alleghany records land sales under the full accrual method as all requirements have been met.
Basic earnings per share of common stock are based on the average number of shares of common stock, par value $1.00 per share, of Alleghany (“Common Stock”) outstanding during the years ended December 31, 2007, 2006 and 2005, respectively, retroactively adjusted for stock dividends. Diluted earnings per share of Common Stock are based on those shares used to calculate basic earnings per common share. Diluted earnings per share of Common Stock also include the dilutive effect of stock-based compensation awards, retroactively adjusted for stock dividends.
Certain prior year amounts have been reclassified to conform to the 2007 presentation.
In September 2006, FASB Statement No. 157, “Fair Value Measurements,” was issued. This Statement provides guidance for using fair value to measure assets and liabilities. The Statement does not expand the use of fair value in any new circumstances. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Alleghany has adopted the provisions of this Statement as of January 1, 2008, and the implementation did not have any material impact on Alleghany’s results of operations and financial condition.
At its September 2006 meeting, the Emerging Issues Task Force reached a consensus with respect to Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements.” This Issue addresses split-dollar life insurance, which is defined as an arrangement in which the employer and an employee share the cash surrender value and/or death benefits of the insurance policy. Premiums may either be split by the employer and the employee, or the employer pays all of the premiums. This Issue applies to endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods. In such instances, an employer should recognize a liability for future benefits in accordance with FASB Statement No. 106 or Opinion No. 12 (depending on whether a substantive plan is deemed to exist) based on the substantive agreement with the employee. This Issue is effective for fiscal years beginning after December 15, 2007. Alleghany has endorsement split-dollar life insurance policies for its executives that are effective during employment as well as retirement. Premiums are paid by Alleghany, and death benefits are split between Alleghany and the beneficiaries of the executive. Death benefits after retirement that inure to the beneficiaries are generally equal to the annual ending salary of the executive at the date of retirement. Alleghany has adopted the provisions of this Issue as of January 1, 2008, and the implementation did not have any material impact on Alleghany’s results of operations and financial condition.
The Securities and Exchange Commission released Staff Accounting Bulletin No. 108 (“SAB 108”), in September 2006. SAB 108 provides guidance on how the effects of the carryover or reversal of prior year financial statement misstatements should be considered in quantifying a current period misstatement. In addition, upon adoption, SAB 108 permits an entity to adjust for the cumulative effect of immaterial errors relating to prior years in the carrying amount of assets and liabilities as of the beginning of the current fiscal year, with an offsetting adjustment to the opening balance of retained earnings. SAB 108 also requires the adjustment of any prior quarterly financial statements within the fiscal year of adoption for the effects of such errors on the quarters when the information is next presented. Alleghany has adopted the provisions of SAB 108 as of January 1, 2007, and the implementation did not have any material impact on its results of operations and financial condition.
In December 2007, FASB Statements No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”), and No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”) were issued. SFAS 141R replaces FASB Statement No. 141, “Business Combinations,” (“SFAS 141”). SFAS 141R requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose additional information regarding the nature and financial effect of the business combination. SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries in the same way - as equity in the consolidated financial statements. SFAS 160 also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. Alleghany will adopt SFAS 141R and SFAS 160 for all business combinations initiated after December 31, 2008. Alleghany will also reclassify its minority interest liabilities as a separate component of shareholders’ equity after December 31, 2008.
On July 14, 2005, Alleghany sold its world-wide industrial minerals business, World Minerals, to Imerys USA, Inc. (the “Purchaser”), a wholly-owned subsidiary of Imerys, S.A., pursuant to a Stock Purchase Agreement, dated as of May 19, 2005, by and among the Purchaser, Imerys, S.A. and Alleghany (the “Stock Purchase Agreement”). Under the terms of the Stock Purchase Agreement, the purchase price was $230.0 million, which was reduced by $13.2 million reflecting contractual obligations to be paid by the Purchaser after the closing, resulting in an adjusted purchase price of $216.8 million (the “Adjusted Purchase Price”). $206.8 million of the Adjusted Purchase Price was paid in cash by the Purchaser to Alleghany on the closing date, with the remaining $10.0 million being held by the Purchaser as security for certain indemnification obligations undertaken by Alleghany pursuant to the Stock Purchase Agreement. The $10.0 million holdback bears interest at the U.S. Treasury 10-year note rate, and is scheduled to be released to Alleghany (to the extent not applied toward such indemnification obligations) during the period covering the fifth through the tenth anniversaries of the closing date. As of the closing date, Alleghany recorded a receivable in the amount of $9.3 million on its balance sheet in respect of the holdback, equal to the $10.0 million face amount less an interest rate discount of $0.7 million. As described in more detail in Note 13, Alleghany established a $0.6 million reserve in connection with its indemnification obligations under the Stock Purchase Agreement during the 2005 second quarter.
Alleghany paid legal, accounting and investment banking fees of $4.9 million in connection with the transaction. The sale of World Minerals produced an after-tax gain of $18.6 million in 2005. Alleghany has classified the operations of World Minerals as a “discontinued operation” in its financial statements for 2005.
Available-for-sale securities at December 31, 2007 and 2006 are summarized as follows (in thousands):
The amortized cost and estimated fair value of debt securities at December 31, 2007 by contractual maturity are shown below (in thousands). 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.
The gross unrealized investment losses and related fair value for debt securities and equity securities at December 31, 2007 and December 31, 2006, were as follows:
At December 31, 2007, all of Alleghany’s debt securities were rated investment grade. At December 31, 2007, non-income producing invested assets were insignificant.
Reinsurance recoverables at December 31, 2007, 2006, and 2005 consist of the following (in thousands):
AIHL’s largest concentration of reinsurance recoverables at December 31, 2007 was $182.6 million, representing 18.9 percent of total reinsurance recoverables, due from subsidiaries of Swiss Reinsurance Company (“Swiss Re”), $118.0 million, representing 12.2 percent of total reinsurance recoverables, due from a subsidiary of The Chubb Corporation (“Chubb”), and $100.6 million, representing 10.4 percent of total reinsurance recoverables, due from a subsidiary of Platinum Underwriters Holdings, Ltd. (“Platinum”). At December 31, 2007, the A.M. Best Company, Inc. (“A.M. Best”) financial strength rating of each of the subsidiaries of Swiss Re and the subsidiary of Platinum was A (Excellent) or higher and A++ (Superior) for the subsidiary of Chubb. Approximately 91.6 percent of AIHL’s reinsurance recoverables balance at December 31, 2007 was due from reinsurers having an A.M. Best financial strength rating of A (Excellent) or higher. AIHL had no allowance for uncollectible reinsurance as of December 31, 2007.
On September 2, 2003, RIC acquired Landmark from Guaranty National Insurance Company (“Guaranty National”) pursuant to a Stock Purchase Agreement dated as of June 6, 2003. In contemplation of the sale of Landmark to RIC, Landmark and Royal Indemnity Company, an affiliate of Guaranty National (“Royal Indemnity”), entered into a 100 percent Quota Share Reinsurance Agreement and an Assumption of Liabilities Agreement, each dated as of September 2, 2003. Pursuant to these two agreements, Royal Indemnity assumed all of Landmark’s liabilities of any nature arising out of or relating to all policies, binders and contracts of insurance issued in Landmark’s name prior to the closing under the Stock Purchase Agreement, and all other liabilities of Landmark. The reinsurance recoverable and loss reserve liability recorded was $17.7 million, $19.9 million and $20.7 million at December 31, 2007, 2006 and 2005, respectively.
RSUI reinsures its other lines of business through quota share treaties. RSUI’s Professional Liability quota share reinsurance treaty, which expired on April 1, 2007, provided reinsurance for policies with limits up to $10.0 million, with RSUI ceding 25 percent of the premiums and losses for policies with limits up to $1.0 million, and 50 percent of the premiums and losses on policies with limits greater than $1.0 million up to $10.0 million. This treaty was not renewed by RSUI, as management decided to retain all of this business. RSUI’s quota share treaty for umbrella/excess renewed on June 1, 2007 and provides reinsurance for policies with limits up to $30.0 million, with RSUI ceding 35 percent of the premium and loss for policies with limits up to $15.0 million and ceding 67.5 percent of the premium and loss for policies with limits in excess of $15.0 million up to $30.0 million. RSUI’s D&O liability line treaty renewed on July 1, 2007 and provides reinsurance for policies with limits up to $20.0 million, with RSUI ceding 35 percent of the premium and loss for all policies with limits up to $10.0 million and ceding 60 percent of the premium and loss for policies with limits in excess of $10.0 million up to $20.0 million.
AIHL Re was formed in June 2006 as a captive reinsurance subsidiary of AIHL to provide catastrophe reinsurance coverage for RSUI. AIHL Re and RSUI entered into a reinsurance agreement for the 2006-2007 coverage period, whereby AIHL Re, in exchange for market-based premiums, took 64 percent of non-earthquake losses and 49 percent of earthquake losses, including a 5 percent co-participation by RSUI, not covered by third-party reinsurers under RSUI’s catastrophe reinsurance program. Because AIHL Re is a wholly-owned subsidiary of AIHL, there was no net reduction in Alleghany’s catastrophe exposure on a consolidated basis as a result of RSUI’s arrangement with AIHL Re. RSUI’s reinsurance coverage with AIHL Re expired on April 30, 2007, and AIHL Re did not participate in RSUI’s catastrophe reinsurance program for the 2007-2008 period.
Homesite’s wind catastrophe exposure is concentrated in the Northeast region of the United States.
In general, Darwin purchases excess of loss reinsurance on a treaty basis to limit its loss from a single occurrence on any one coverage part of any one policy. With respect to Darwin’s medical lines of business,
CATA uses reinsurance to protect against severity losses. In 2007, CATA reinsured individual property and casualty and contract surety risks in excess of $1.5 million with various reinsurers. The commercial surety line was reinsured for individual losses above $1.25 million. In addition, CATA purchases facultative reinsurance coverage for risks in excess of $6.0 million on property and casualty and $15.0 million on commercial surety.
Activity in liability for losses and loss adjustment expenses in 2007, 2006, and 2005 is summarized as follows (in thousands):
Total gross loss adjustment expense reserves decreased by $276.4 million during 2006, from $2,581.0 million to $2,304.6 million. Of this decrease, $760.5 million was due to the property lines of business, primarily reflecting a decrease in RSUI’s losses and loss adjustment expenses connected to the 2005 hurricane activity, as payments were made by RSUI during 2006 and reinsurance recoveries were received during 2006. The $760.5 million was partially offset by $491.8 million increase in reserves related to casualty lines of business, primarily reflecting increased earned premium in D&O liability, medical malpractice and professional liability, combined with limited paid loss activity for the current and prior casualty accident years.
adjustment was partially offset by reserve releases related to Hurricane Wilma in the 2005 fourth quarter and 2004 third quarter hurricanes. With respect to the 2004 third quarter hurricanes, the releases reflected a determination that paid losses for such hurricanes were at or close to ultimate expected losses.
Total debt at December 31, 2007 and 2006 is summarized as follows (in thousands):
Alleghany Funding’s notes of $80 million were secured by a $91.5 million installment note receivable (see Note 4) and matured in January 2007. Alleghany Funding entered into a related interest rate swap agreement with a notional amount of $86.2 million for the purpose of matching interest expense with interest income. This swap was pay variable, receive variable. Alleghany Funding paid a variable rate equal to the one-month commercial paper rate plus 0.0625 percent and received a variable rate equal to the three-month LIBOR rate plus 0.375 percent. The interest rate swap matured in January 2007, without gain or loss.
and general corporate purposes. Under the Credit Agreement, at Alleghany’s option, borrowings bear interest at a rate based on the prevailing rates for dollars in the London interbank market or the greater of the federal funds rate and the administrative agent bank’s prime rate plus applicable margins. A commitment fee of 1/8 of 1 percent per annum of the unused commitment is charged. The Credit Agreement requires Alleghany, among other things, to maintain tangible net worth of not less than $1.89 billion, limit the amount of certain other indebtedness, and maintain certain levels of unrestricted liquid assets. Such agreement also contains restrictions with respect to mortgaging or pledging any of Alleghany’s assets and the consolidation or merger with any other corporation. At December 31, 2007, Alleghany was in full compliance with these requirements and restrictions. There were no borrowings under the Credit Agreement in 2007.
Income tax expense (benefit) from continuing operations consists of the following (in thousands):
The effective income tax rate on continuing operations for 2005 is low relative to 2006 and 2007 due to the negative impact of significant catastrophe losses on Alleghany’s net income incurred during 2005.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2007 and 2006 are as follows (in thousands):
At December 31, 2007, approximately $412.2 million of the equity of all of Alleghany’s subsidiaries was available for dividends or advances to Alleghany at the parent level. At that date, approximately $2.0 billion of Alleghany’s total equity of $2.79 billion was unavailable for dividends or advances to Alleghany from its subsidiaries. With respect to AIHL’s insurance operating units, they are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid by them without prior approval
Statutory net income of Alleghany’s insurance operating units was $344.5 million and $237.3 million for the years ended December 31, 2007 and 2006, respectively. Combined statutory capital and surplus of Alleghany’s insurance operating units was $1,756.9 million and $1,397.3 million at December 31, 2007 and 2006, respectively.
As of December 31, 2007, Alleghany had share-based payment plans for parent-level employees and non-employee directors. As described in more detail below, parent-level share-based payments to current employees consist only of restricted stock awards, including restricted stock units, and performance share awards, and no stock options. Parent-level share-based payments to non-employee directors consist of annual awards of stock options and restricted stock, including restricted stock units. In addition, as of December 31, 2007, RSUI, EDC and Darwin had their own share-based payment plans, which are described below.
A summary of the status of Alleghany’s nonvested shares as of December 31, 2007, and changes during the year ended December 31, 2007, is presented below:
during the years ended December 31, 2007, 2006 and 2005, was $1.5, $1.9 million and $2.0 million, respectively.
Alleghany provides through its 2002 Long-Term Incentive Plan (the “2002 LTIP”) incentive compensation to management employees of the type commonly known as restricted shares, stock appreciation rights, performance shares and performance units, as well as other types of incentive compensation. Awards 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 2002 LTIP, the following types of awards are outstanding:
(ii) Restricted Share or Restricted Stock Unit Awards - Alleghany has awarded to certain management employees restricted shares of Common Stock. These awards entitle the participants to a specified maximum amount equal to the value of one share of Common Stock for each restricted share or restricted stock unit issued to them based on the market value on the payment date. In most instances, payouts are made provided defined levels of performance are achieved. As of December 31, 2007, 58,442 restricted shares were outstanding, of which 5,408 were granted in 2007, 31,385 were granted in 2004 and 21,649 were granted in 2003. The expense is recognized ratably over the performance period, which can be extended under certain circumstances. The 2004 awards are expected to vest over four years.
RSUI has a Restricted Stock Unit Plan (the “RSUI Plan”) for the purpose of providing equity-like incentives to key employees. Under the RSUI Plan, restricted stock units (“units”) are issued. Additional units, defined as the “Deferred Equity Pool,” were issued in 2006 and 2007, 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 pursuant to SFAS 123R, 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 2007, 2006 and 2005, RSUI recorded $43.9, $34.8 million and $14.1 million, respectively, in compensation expense related to the RSUI Plan. During the same periods, a deferred tax benefit of $15.4 million, $12.2 million and $4.9 million, respectively, related to the compensation expense was recorded.
Under the 2003 Restricted Stock Plan (the most significant of these plans), Darwin reserved 1,650,000 of its authorized shares of common stock (approximating 10 percent of all shares of common stock currently outstanding). These restricted stock awards generally vest at a rate of 50 percent on each of the third and fourth anniversaries of the grant date, contingent on the continued employment of the grantee at Darwin.
EDC has a share-based payment plan for each of its two senior executives. Under the plans, EDC reserved 4,000 of its authorized shares of common stock (approximating 1.6 percent of all shares of common stock currently outstanding). These restricted stock awards generally vest depending on the compound annual growth rate of EDC’s equity, with the earliest vesting date being December 31, 2011. If a minimum of 7 percent growth rate is not achieved by December 31, 2016, all restricted stock will be forfeited. The plan resulted in nominal increases in Alleghany’s compensation expense in 2007.
As previously noted, SFAS 158 was issued in September 2006 and adopted by Alleghany as of December 31, 2006. SFAS 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. The changes are to be reported in comprehensive income as of December 31, 2006. Past standards only required an employer to disclose the complete funded status of its plans in the notes to the financial statements.
Contingently issuable shares of 57,877, 88,201 and 71,980 were potentially available during 2007, 2006 and 2005, 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.
Alleghany leases 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 2020. Rent expense was $9.4 million, $7.8 million and $8.2 million in 2007, 2006 and 2005, respectively.
The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2007 were as follows (in millions):
AIHL’s reserve for unpaid losses and loss adjustment expenses includes $22.9 million of gross reserves and $22.7 million of net reserves, and $23.8 million of gross reserves and $23.7 million of net reserves at December 31, 2007 and December 31, 2006, respectively, for various liability coverages related to asbestos and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976. This subsidiary exited this business in 1976. Reserves for asbestos and environmental impairment claims cannot be estimated with traditional loss reserving techniques because of uncertainties that are greater than those associated with other types of claims. Factors contributing to those uncertainties include a lack of historical data, the significant periods of time that often elapse between the occurrence of an insured loss and the reporting of that loss to the ceding company and the reinsurer, uncertainty as to the number and identity of insureds with potential exposure to such risks, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Loss reserve estimates for such environmental and asbestos exposures include case reserves, which also reflect reserves for legal and other loss adjustment expenses and IBNR reserves. IBNR reserves are determined based upon historic general liability exposure base and policy language, previous environmental loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.
For both asbestos and environmental reinsurance claims, CATA establishes case reserves by receiving case reserve amounts from its ceding companies, and verifies these amounts against reinsurance contract terms, analyzing from the first dollar of loss incurred by the primary insurer. In establishing the liability for claims for asbestos related liability and for environmental impairment claims, management considers facts currently known and the current state of the law and coverage litigation. Additionally, ceding companies often report potential losses on a precautionary basis to protect their rights under the reinsurance arrangement, which generally calls for prompt notice to the reinsurer. Ceding companies, at the time they report such potential losses, advise CATA of the ceding companies’ current estimate of the extent of such loss. CATA’s claims department reviews each of the precautionary claims notices and, based upon current information, assesses the likelihood of loss to CATA. Such assessment is one of the factors used in determining the adequacy of the recorded asbestos and environmental reserves. Although Alleghany is unable at this time to determine whether additional reserves, which could have a material impact upon its results of operations, may be necessary in the future, Alleghany believes that CATA’s asbestos and environmental reserves are adequate at December 31, 2007.
The Products Liability Indemnification is divided into two parts, the first relating to products liability claims arising in respect of events occurring during the period prior to Alleghany’s acquisition of the World Minerals business from Johns Manville Corporation, Inc. (f/k/a Manville Sales Corporation) (“Manville”) in July 1991 (the “Manville Period”), and the second relating to products liability claims arising in respect of events occurring during the period of Alleghany ownership (the “Alleghany Period”). Under the terms of the Stock Purchase Agreement, Alleghany will provide indemnification at a rate of 100 percent for the first $100.0 million of losses arising from products liability claims relating to the Manville Period and at a rate of 50 percent for the next $100.0 million of such losses, so that Alleghany’s maximum indemnification obligation in respect of products liability claims relating to the Manville Period is $150.0 million. This indemnification obligation in respect of Manville Period products liability claims will expire on July 31, 2016. The Stock Purchase Agreement states that it is the intention of the parties that, with regard to losses incurred in respect of products liability claims relating to the Manville Period, recovery should first be sought from Manville, and that Alleghany’s indemnification obligation in respect of products liability claims relating to the Manville Period is intended to indemnify the Purchaser for such losses which are not recovered from Manville within a reasonable period of time after recovery is sought from Manville. In connection with World Minerals’ acquisition of the assets of the industrial minerals business of Manville in 1991, Manville agreed to indemnify World Minerals for certain product liability claims, in respect of products of the industrial minerals business manufactured during the Manville Period, asserted against World Minerals through July 31, 2006. World Minerals did not assume in the acquisition liability for product liability claims to the extent that such claims relate, in whole or in part, to the Manville Period, and Manville should continue to be responsible for such claims, notwithstanding the expiration of the Manville indemnity in 2006.
For products liability claims relating to the Alleghany Period, Alleghany will provide indemnification for up to $30.0 million in the aggregate. The $10.0 million holdback from the Adjusted Purchase Price paid at the closing secures performance of this indemnification obligation relating to the Alleghany Period, and, unless and until the holdback amount is exhausted, will be charged for any claim for payment in respect of this indemnification obligation that would otherwise be made to Alleghany. In addition to the indemnification obligation undertaken by Alleghany in respect of products liability claims relating to the Alleghany Period, the Stock Purchase Agreement provides that, after the closing, Alleghany will continue to make available to World Minerals $30.0 million per policy period of Alleghany’s umbrella insurance coverage in effect on a Alleghany group-wide basis for policy periods beginning on April 1, 1996 (prior to April 1, 1996, World Minerals had its own umbrella insurance coverage). This portion of Alleghany’s umbrella insurance coverage will be available to World Minerals for general liability claims as well as for products liability claims. The Stock Purchase Agreement states that it is the intention of the parties that, with regard to losses incurred in respect of products liability claims relating to the Alleghany Period, recovery should first be sought under any available World Minerals insurance policies and second under the portion of Alleghany’s umbrella insurance coverage made available to World Minerals after the closing, and that Alleghany’s indemnification obligation in respect of products liability claims relating to the Alleghany Period is intended to indemnify the Purchaser for such losses in respect of which coverage is not available under either the World Minerals insurance policies or under such portion of Alleghany’s umbrella insurance coverage. Alleghany’s indemnification obligation in respect of Alleghany Period products liability claims will expire on July 14, 2015, which is the tenth anniversary of the closing date.
defendants that had allegedly supplied such products to plaintiffs’ employers. Through the date of sale, World Minerals did not incur any significant expense in respect of such cases. Based on Alleghany’s experience to date and other analyses, Alleghany established a $600 thousand reserve in connection with the Products Liability Indemnification for the Alleghany Period. Such reserve was $431 thousand and $560 thousand at December 31, 2007 and 2006.
The estimated carrying values and fair values of Alleghany’s financial instruments are as follows (in millions):
Investments: For purposes of the above table, investments include available-for-sale securities as well as investments in partnerships that are included in other invested assets. Investments exclude Alleghany’s investment in Homesite, which is included in other invested assets.
The fair value of available-for-sale equity and debt securities are recorded at fair value based on quoted market prices or dealer quotes. Quoted market prices are typically available and utilized for equity securities and U.S. government obligations. Third-party dealer quotes are typically utilized for all other types of fixed income securities. In developing such quotes, dealers will utilize the terms of the security and market-based inputs. Terms of the security include coupon, maturity date, and any special provisions that may, for example, enable the investor, at his election, to redeem the security prior to its scheduled maturity date. Market-based inputs include the level of interest rates applicable to comparable securities in the market place and current credit rating(s) of the security.
The fair value of investments in partnerships is based upon quoted market prices for the securities owned, as quoted by the general partner of the entity in which such investment was held.
Information related to Alleghany’s reportable segment is shown in the table below. Property and casualty insurance and surety operations are conducted by AIHL through its insurance operating units RSUI, CATA, EDC and Darwin. In addition, AIHL Re, established in June 2006, is a wholly-owned subsidiary of AIHL that is available to provide reinsurance to Alleghany’s insurance operating units and affiliates.
On May 26, 2006, Alleghany Properties completed a sale of real property for $29.3 million, recorded in other income, which resulted in a net pre-tax gain of $23.1 million for 2006.
On July 18, 2007 (the “Acquisition Date”), AIHL completed its acquisition of EDC for a purchase price of approximately $198.1 million, including approximately $5.6 million of incurred acquisition costs. After giving effect to the transaction, AIHL owned approximately 98.4 percent of the common stock of EDC with EDC senior management owning the remainder. EDC is included as an insurance operating unit within AIHL for segment reporting purposes.
Available-for-sale securities consist of high-quality fixed-income securities and money market funds, over half of which are currently on deposit with the California Department of Insurance to comply with insurance regulations.
The $120.0 million investment plus $0.7 million of transactions costs are reported as a component of other invested assets as of December 31, 2006. Going forward, Alleghany’s interest in Homesite will be included in corporate activities for segment reporting purposes and will be accounted for under the equity-method of accounting.
The amount of goodwill and intangible assets that is reported separately on Alleghany’s consolidated balance sheets, and that arose from prior acquisitions of majority- or wholly-owned subsidiaries that are included in Alleghany’s consolidated balance sheets at December 31, 2007 and 2006 are as follows (in thousands):
Other assets shown in Alleghany’s consolidated balance sheets include the following amounts at December 31, 2007 and 2006 (in thousands):
Other liabilities shown in Alleghany’s consolidated balance sheets include the following amounts at December 31, 2007 and 2006 (in thousands):
Selected quarterly financial data for 2007 and 2006 are presented below (in thousands, except per share amounts):
We have audited the accompanying consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alleghany Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 25, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
In our opinion, Alleghany Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).