The Company leases office space in San Antonio, Texas for its corporate headquarters as well as for certain support functions for Argonaut Insurance Company. Argonaut Insurance Company’s headquarters are located in a facility that consists of an office building on approximately two acres of land in Menlo Park, California. Argonaut Great Central’s headquarters are located in a facility in Peoria, Illinois. Argonaut Insurance Company and Argonaut Great Central own these facilities. Colony leases its home office space in Richmond, Virginia. Rockwood leases its home office space in Rockwood, Pennsylvania. Grocers leases its home office space in Portland, Oregon. Trident leases its home office space in San Antonio, Texas. In addition, the Company has entered into other leases in conjunction with its operations at various locations throughout the country. The Company believes that its properties are adequate for its present needs.
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 37. This discussion contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.
Consolidated net interest income increased in 2004 as compared to 2003 and 2002 due to higher invested balances resulting from positive cash flows and capital raising initiatives which began in the fourth quarter of 2003 and continued into 2004. Total invested assets totaled $1,783.9 million, $1,553.2 million and $1,181.3 million as of December 31, 2004, 2003 and 2002, respectively.
The consolidated benefit for income taxes for the year ended December 31, 2004 was $11.1 million, and includes a reduction of the deferred tax valuation allowance of $24.0 million. During 2004, the Company reduced its liability for accrued taxes by $10.8 million due to the state of California enacting a law providing for a partial tax deduction for certain insurance company dividends received by a company subject to California corporate income tax. The consolidated provision for income taxes for the year ended December 31, 2003 was $26.3 million, including a reduction in the deferred tax asset valuation allowance of $22.8 million. The consolidated provision for income taxes for the year ended December 31, 2002 was $65.9 million, including the establishment of a valuation allowance on deferred tax of $71.9 million. The reduction of the deferred tax valuation allowance in 2004 and 2003 was based on management’s consideration of limited amounts of future income in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, “Accounting for Income Taxes” combined with earnings reported in 2004. Management anticipates the valuation allowance will ultimately be recovered in the future. The Company evaluates the adequacy of the valuation allowance on a regular basis.
Excess and Surplus Lines. Excess and surplus lines insurance carriers provide insurance that is unavailable or difficult to obtain by businesses in the admitted market due to the unique characteristics of the insureds or the lack of insurers writing such coverage. The excess and surplus lines market allows Colony to underwrite certain risks with more flexible policy terms at unregulated premium rates. Colony provides commercial liability, commercial property, products liability and environmental liability coverages to commercial enterprises, including restaurants, artisan contractors, day-care centers and manufacturers, and professional liability coverages for health care providers and other professionals. Colony is approved as a non-admitted insurer in 48 states, the District of Columbia and the U.S. Virgin Islands.
Gross written premiums for the year ended 2004 increased primarily as a result of increases in renewal premiums. Renewal premiums for the year ended 2004 totaled $203.2 million, compared to $140.7 million and $83.2 million for the same periods in 2003 and 2002, respectively. A larger base of expiring premiums was the primary driver for the increase in renewal premiums and to a lesser extent rate increases. Gross written premiums from new business declined to $237.1 million in 2004, compared to $268.0 million in 2003 and $188.0 million for 2002. The decrease in new business in 2004 as compared to 2003 was primarily attributable to increased competition primarily in property lines and larger casualty risks. Additionally, as a result of the hurricane activity in the third quarter of 2004, the Company did not issue new policies in Florida from August 13 to September 27, 2004. Also reducing gross written premiums were cancellations and endorsements of approximately $19.1 million for the year ended 2004, compared to $24.1 million and $13.3 million for 2003 and 2002, respectively.
The increase in earned premiums in 2004 as compared to 2003 and 2002 was primarily attributable to the same factors noted above with respect to gross written premiums.
The excess and surplus lines segment’s loss ratio was 65.4% for 2004 compared to 62.0% for 2003 and 63.4% for 2002. Included in the 2004 loss ratio is $15.4 million in losses resulting from the hurricane activity in the southeastern United States during the third quarter of 2004, contributing approximately five percentage points to the loss ratio. Prior year loss development of $4.2 million was recognized during 2004. This resulted primarily from strengthening of case and incurred but not reported losses of this segment’s other liability business for accident years 2003 and prior due to higher than anticipated frequency and severity. Loss reserves for the excess and surplus lines segment were $474.2 million, $345.5 million and $180.1 million as of December 31, 2004, 2003 and 2002, respectively. Loss reserves as of December 31, 2004 represent management’s best estimate based on current facts and trends within this segment; however, due to the inherent uncertainties in estimating ultimate loss reserves, the potential for future development exists.
The following table summarizes the results of operations for the risk management segment:
For the year ended 2004, gross written premiums totaled $181.7 million compared to $197.4 million in 2003. During the first quarter of 2003, management decided to focus writings on casualty risk management solutions written on a loss sensitive basis for larger insureds and reduced the number of product offerings and distribution channels. As a result, workers’ compensation policies written on a guaranteed cost basis were substantially reduced and the Company discontinued writing new wrap up policies for large multi-insured construction projects as well as smaller guaranteed cost policies. This restructuring resulted in decreases in the risk management segment’s gross written premiums for the years ended December 31, 2003 and 2004. The decision to focus on loss sensitive policies resulted in a reduction in gross written premiums from new business to $40.2 million in 2004 from $57.0 million in 2003. Gross written premiums from renewal business on the loss sensitive policies were $92.3 in 2004 and $53.1 million in 2003, primarily as a result of the Kemper renewal rights acquisition (see discussion below). The shift in focus to loss sensitive accounts resulted in a decrease in gross written premiums for non-strategic products. These non-strategic products produced $5.0 million in gross written premiums in 2004 compared to $47.7 million in 2003.
During 2003, Argonaut Insurance Company entered into an agreement with Kemper Insurance Company to purchase the renewal rights for certain national accounts. Included in the $197.4 million of risk management premiums referenced above for 2003 is $22.7 million of new business generated under this agreement.
Losses and loss adjustment expenses of $71.9 million, $100.2 million and $94.5 million for the years ended 2004, 2003 and 2002, respectively, equate to loss ratios of 62.1%, 81.9% and 86.5%. Loss reserves for this segment were $637.9 million, $653.7 million and $630.0 million as of December 31, 2004, 2003 and 2002, respectively. The improvement in the loss ratio over the three year period is the result of the Company re-underwriting this book of business beginning in 2001 and continuing into 2004. Additionally, beginning in 2003, the Company focused on writing loss sensitive accounts either through large deductible or retrospectively rated policies with annual policy premium generally between $500,000 and $5.0 million. Typically, loss sensitive accounts have produced a better loss ratio than the products that the Company exited.
Losses and loss adjustment expenses for the year ended 2004 have been reduced by $5.3 million of favorable development related to business written in prior to 2004. This reduction was the result of favorable development on prior accident years recognized during 2004, mainly attributable to the 2001, 2002 and 2003 accident years; this amount is after considering unfavorable development on prior accident years. Beginning in 2001, management began re-underwriting the book of business emphasizing less hazardous insureds, and began shifting the book of business to loss sensitive policies where the insured retains a significant amount of losses. As a result of these initiatives and as the actuarial data for these years matured, management has determined that its best estimate of loss and loss adjustment expense should be reduced for those three accident years.
Specialty Commercial. Argonaut Great Central, Rockwood and Grocers provide specialty commercial insurance coverage. Argonaut Great Central specializes in commercial multi-peril, workers’ compensation and umbrella insurance coverage in three broadly defined markets: food and hospitality, retail services and organizations and institutions. Rockwood provides commercial property and casualty insurance primarily in Pennsylvania and Maryland. Rockwood focuses on underwriting workers’ compensation coverage, general liability and other property and casualty coverage for commercial and mining risks. In December 2003, the Company acquired certain assets, personnel and the right to renew business underwritten by the Grocers Insurance segment of Royal and Sun Alliance USA. Grocers underwrites property, liability and workers’ compensation programs to privately owned independent grocers throughout the United States.
The expense ratio for the year ended December 31, 2004 was 30.1%, compared to 28.7% and 28.8% for 2003 and 2002, respectively. The increase in the expense ratio was primarily attributable to increased start-up costs resulting from the Grocers renewal rights agreement previously discussed. Renewal rights acquisitions typically result in a higher expense ratio until the earned premium equates to the amount of premium in force.
The increase in net investment income for the year ended December 31, 2004 as compared to 2003 was primarily attributable to higher invested balances resulting from increased cash flows. The decline in net investment income for the year ended December 31, 2003 as compared to 2002 was primarily attributable to lower yields. Invested assets were $302.4 million, $246.3 million and $230.0 million as of December 31, 2004, 2003 and 2002, respectively.
The following table summarizes the results of operations for the public entity segment:
The expense ratio for the year ended December 31, 2004 was 33.5% compared to 31.5% and 32.2% for the same periods of 2003 and 2002, respectively. The increase in the expense ratio in 2004 is primarily a result of higher acquisition costs associated with the 2003 renewal rights transaction. The decrease in the expense ratio in 2003 as compared to 2002 was primarily a result of lower expense growth in comparison with the premium growth, partially offset by the decrease in ceding commission on the segment’s quota share reinsurance agreement from 2002 to 2003.
The increase in net investment income was primarily attributable to higher invested balances due to increased cash flows from operations. Net invested assets were $104.5 million as of December 31, 2004, resulting primarily from positive cash flows from operations coupled with a capital allocation from the risk management segment.
For the year ended December 31, 2004, the run-off segment’s underwriting income was zero, compared to underwriting losses of $12.7 million and $67.8 million for the same periods of 2003 and 2002, respectively.
The following table represents the components of gross loss reserves for the run-off lines for each of the years in the three-year period ended December 31, 2004.
For the year ended December 31, 2002, the Company strengthened its net asbestos reserves by $59.8 million. The Company strengthened these reserves by $7.0 million in the third quarter of 2002 due to the identification of policies written from 1985 into the early 1990’s that failed to include the asbestos coverage exclusion. The Company determined that the policies issued with this error were confined to general liability policies processed at one particular office. Additionally, the Company completed its 2002 annual analysis of reserves for the run-off lines in the fourth quarter of 2002 and as a result strengthened its net asbestos reserves by $52.8 million. The decision to strengthen asbestos reserves was the result of an evaluation and review of exposure to asbestos claims, particularly in light of industry and litigation trends, actual claims experience, and actuarial analysis by the Company’s consulting and internal actuaries.
The following table represents a reconciliation of the number of asbestos and environmental claims outstanding for each of the years in the three-year period ended December 31, 2004.
The number of claims opened during the three years ended December 31, 2004 were from the following sources:
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2004.
The Company’s principal cash flow sources are premiums and investment income. The primary cash outflows are claim payments and operating expenses. The nature of insurance is that cash collected on premiums written is invested, interest and dividends are
For the year ended December 31, 2004, net cash provided by operating activities was $122.9 million, compared to $182.2 million for the year ended December 31, 2003 and $117.7 million for the year ended December 31, 2002. The decrease in cash flows from operations was primarily attributable to a slower growth rate in gross written premiums in 2004 as compared to 2003, coupled with an increase in claims payments in the run-off lines (see “Results of Operation - Run-off lines on pages 25 - 28). The cash flow provided by operating activities in 2003 and 2002 was primarily the result of improved underwriting results and increased premium volume.
In the first quarter of 2003, the Company sold certain parcels of real estate located in Southern California for approximately $64 million. During the year ended December 31, 2004, the Company received principal payments totaling approximately $8.6 million. As of December 31, 2004, the Company holds notes receivable on these properties of approximately $37.8 million, which are due and payable during 2005.
During 2004, the Company, through a series of statutory trusts, sold $83.0 million of Floating Rate Capital securities (the “Capital Securities) (liquidation amount $1,000 per Capital Security) in a series of private sales. In conjunction with the sales of the Capital Securities, the trusts sold $2.6 million of Floating Rate Common Securities to the Company. The trusts used the proceeds from these sales to purchase $85.6 million of Floating Rate Junior Subordinated Debentures (the “Debentures”) from the Company. The interest rates on the Debentures and the Capital Securities are equal to the 3-Month LIBOR plus a margin ranging from 3.55% to 3.85%, reset quarterly. For selected Debentures, the interest rates are not to exceed 12.5% prior to the coupon cap date, which is approximately 5 years after the issuance date. The remaining debentures have interest rates that are not to exceed the highest rate permitted by New York Law, currently 16.0%, prior to the coupon cap date. The Debentures are unsecured and are subordinate in right of payment to all of the Company’s future senior indebtedness. The Debentures are due 30 years after issuance, but may be redeemed after the five-year anniversary at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest on the date of redemption. The Debentures may be redeemed prior to the five-year anniversary date upon the occurrence of specific events at a price equal to 107.5% to 101% plus accrued and unpaid interest to the date of redemption.
senior indebtedness. The Debentures are due 30 years after issuance, but may be redeemed after the five-year anniversary at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest on the date of redemption. The Debentures may be redeemed prior to the five-year anniversary date upon the occurrence of specific events at a price equal to 107.5% to 100.95% plus accrued and unpaid interest to the date of redemption.
The Company’s insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to cover operating expenses. During the three years ended December 31, 2004, the Company’s liquidity generated from operations and investment income were sufficient to meet obligations. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as satisfy its commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
The ADC provides up to $119.0 million of reinsurance for future adverse development, if any, on workers’ compensation, commercial multiple peril, general liability and asbestos, environmental and other latent losses. The Company has $68.8 million of unused coverage under the ADC development reinsurance agreement for future adverse development. The cessions for adverse development are calculated on a tiered structure and subject to certain limitations. The Company has the option to commute the ADC at any time if the funds withheld balance is positive. The Company has received irrevocable letters of credit in the amount of $89.8 million as collateral against balances due from this reinsurer.
Credit risk is a major factor of the overall enterprise risk within the Company, and the Company has established policies and procedures to protect the Company against such losses, particularly as respects its investment holdings, and its receivable balances from insureds and reinsurers.
The Company’s current investment strategy is to invest in callable U.S. Agency securities and minimize exposure to the equity market. Management believes this strategy will result in above average short term yields while protecting the portfolio from rising interest rates. As of December 31, 2004, the investment mix of the pension portfolio was 95% U.S Government agencies and 5% short term investments. The fair market value of the investment portfolio as of December 31, 2004 was $31.2 million and included net unrealized losses of $0.2 million.
Effective November 2003, the Company curtailed the pension plan. This curtailment resulted in a reduction of pension expense of $3.9 million, which was recognized in the results of operations for the year ended December 31, 2003. During the year ended December 31, 2004, the Company did not incur any pension expense. As of December 31, 2004, the Company has a prepaid pension asset of approximately $6.8 million. The estimated pension liability as of December 31, 2004 was $24.9 million. Due to the curtailment in 2003, all participants were vested as of February 2004. Based on the current funding status of the pension plan, the effects of the curtailment, the expected changes in pension plan asset values and pension obligations in 2004, the Company does not believe any significant funding of the pension plan will be required during the year ended December 31, 2005. Management is in the preliminary stages of evaluating formal termination of the pension plans. Termination of the plan may result in additional expense being incurred by the Company. However, as of this time, management is unable to estimate the additional expense, if any.
Fayez Sarofim The Company utilizes Fayez Sarofim & Co. to manage approximately $161.2 million of its investment portfolio, for which an investment advisory fee is paid. Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez Sarofim, a member of the Company’s Board of Directors, is the majority shareholder. Total fees for services paid to Fayez Sarofim & Co. were approximately $0.4 million, $0.5 million and $0.5 million for the years ended December 31, 2004, 2003 and 2002, respectively. The Company believes that this transaction has been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
The Company and Asset Allocation Management Company, LLC (“AAM”) are parties to an agreement dated March 1, 2004, pursuant to which AAM manages a portion of its fixed income securities in accordance with the Company’s investment policy. Century Capital Management, LLC (“CCML”), a successor to Century Capital Management, Inc. manages two partnerships (Century Capital Partners II, L.P. and CCPIII) that collectively have a majority ownership interest in AAM. As of December 31, 2004, AAM managed $706.4 million of fixed income securities. The Company paid AAM $0.6 million for services provided in 2004, which constituted less than 5% of AAM’s consolidated gross revenues for 2004.
Allan W. Fulkerson, who is a member of the Company’s Board of Directors, serves as a consultant to CCML. Prior to December 31, 2004, Mr. Fulkerson also served as a director of the general partner of, CCPIII. Mr. Fulkerson retains a 7% ownership interest in the general partner of CCPIII. As such, he has an indirect ownership interest in AAM of less than one-half of one percent.
On March 31, 2003, Colony Insurance Company entered into a quota share reinsurance agreement with HCC. For the year ended December 31, 2004, the Company ceded approximately $62.0 million of gross written premiums, $58.5 million of earned premiums and $35.7 million of losses and loss adjustment expenses. The Company earned a ceding commission of $11.6 million.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share reinsurance agreement with HCC. Under the original terms of the agreement, the Company assumed 3.33% of the premiums and losses under HCC’s USA Directors and Officers Liability program, and 5.0% of the premiums and losses under HCC’s International Directors and Officers Liability program. Effective January 1, 2004, the agreement was amended and Argonaut Insurance Company now assumes 1.5% of the premiums and losses under each program. For the year ended December 31, 2004, gross written premiums under this program totaled $9.1 million, earned premiums totaled $14.7 million and losses totaled $9.3 million. For the year ended December 31, 2004, the Company expensed ceding and other commissions of $4.8 million related to this business.
The Company has no material obligations under a guarantee contract. The Company has no material retained or contingent interests in assets transferred to an unconsolidated entity. The Company has no material obligations, including contingent obligations, under contracts that would be accounted for as derivative instruments. The Company has no unrecorded obligations, arising out of a variable interest in an unconsolidated entity held by, and material to, the Company, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the Company. Accordingly, the Company has no material off-balance sheet arrangements, other than operating leases.
As of December 31, 2004, the Company recorded gross loss reserves of $1,607.5 million and loss reserves, net of reinsurance, of $1,060.8 million, prior to the effects of the adverse development cover. The Company estimates its range of reserves, net of reinsurance, at $928.2 million to $1,250.4 million. Management believes it has recorded its best estimate as of December 31, 2004, based on information currently known to the Company.
Inconsistent judicial decisions and legislative actions continue to broaden liability and scope of policy coverage and to increase the severity of claim payments. As a result, the uncertainties inherent in estimating the ultimate claim costs on the basis of past
claims costs have been heightened, further complicating the already complex loss reserving process. Final claim payments, however, may differ from the established reserves, particularly when these payments may not occur for several years. Any adjustments to reserves are reflected in the results for the year during which the adjustments are made.
Deferred Tax Assets and Liabilities. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are recognized for temporary differences that will result in taxable amounts in future years. Deferred tax assets are recognized for deductible temporary differences and tax operating loss and tax credit carryforwards. The deferred tax assets and liabilities are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The components of the Company’s deferred tax asset are temporary differences primarily attributable to loss reserve discounting and unearned premium reserves. The Company’s deferred tax liabilities resulted primarily from unrealized gains in the investment portfolio.
Realization of deferred tax assets is dependent upon the Company’s generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in the carryback period, generally two years. At the end of 2002, a valuation allowance of $71.9 million was established by the Company against the deferred tax asset. During 2004 and 2003, the valuation allowance was reduced by $24.0 million and $22.8 million, respectively due to management’s consideration of future income in accordance with SFAS No. 109. The Company expects that it will ultimately recognize the deferred tax asset in the future and regularly evaluates the deferred tax asset valuation allowance.