New York City, New York (Argo Group US and Colony Specialty)
For the year ended December 31, 2013, we reported net income of $143.2 million, or $5.14 per fully diluted share. For the year ended December 31, 2012, we reported net income of $52.3 million, or $1.83 per fully diluted share. For the year ended December 31, 2011, we reported net loss of $81.9 million, or ($2.74) per fully diluted share.
The increase in gross written and earned premiums for the year ended December 31, 2013 as compared to the same periods ended 2012 and 2011 was primarily attributable to growth in our United States and Syndicate 1200 segments, coupled with the start up of our Brazil operations. Earned premiums for our United States segments increased to $759.9 million (on gross written premiums of 1,016.8 million) for the year ended December 31, 2013 compared to $718.4 million (on gross written premiums of $957.3 million) and $721.2 million (on gross written premiums of $913.3 million) for the same periods in 2012 and 2011, respectively. The increase in earned premiums was primarily attributable to growth in our Excess and Surplus Lines segment. Partially offsetting these increases were declines in our Commercial Specialty segment due to planned reduction in our retail and public entity units. Earned premiums for our Syndicate 1200 segment increased to $401.7 million (on gross written premiums of $583.9 million) from $320.8 million (on gross written premiums of $533.4 million) and $259.3 million (on gross written premiums of $438.5 million) for the same periods ended 2012 and 2011, respectively. Growth was attributable to increases in our property and liability units, coupled with the introduction of the specialty and aerospace units in 2011, in addition to an increased participation on the Syndicate by the group during that period. Earned premiums for our Bermuda operations were $103.5 million (on gross written premiums of $222.1 million), $120.7 million (on gross written premiums of $208.2 million) and $101.5 million (on gross written premiums of $193.0 million) for the years ended December 31, 2013, 2012 and 2011, respectively. Declines in the property reinsurance market were offset by increased premium writings in our professional lines and excess casualty units. Our operations in Brazil, which began writing business in 2012, contributed $38.7 million of earned premiums (on gross written premiums of $65.6 million) for the year ended December 31, 2013 compared to $26.6 million (on gross written premiums of $46.8 million) for the same period ended 2012.
We have purchased foreign currency 90 day forward contracts to manage currency exposure on losses related to selected catastrophe events. The term of these contracts gives us flexibility to adjust the notional amount of the contracts based on payments made and changes in estimates of future losses. We do not apply hedge accounting to these contracts, and as a result, all gains (losses) are recognized in net realized investment and other gains. For the year ended December 31, 2013, we recognized $2.6 million in realized losses from the currency forward contracts. Foreign currency exchange losses related to the loss reserves recorded for these events were negligible for the year ended December 31, 2013. For the years ended December 31, 2012 and 2011, we recognized $0.5 million and $4.6 million, respectively, in realized gains from the currency forward contracts, which were offset by $0.6 million and $4.3 million, respectively, in foreign currency exchange losses related to the loss reserves recorded for these events. The foreign currency exchange losses related to these loss reserves and the realized gains (losses) from the currency forward contracts are reported under the Corporate and Other segment.
Included in losses and loss adjustment expenses for the year ended December 31, 2012 was $75.2 million in catastrophe losses from storm activity in the United States, including Hurricane Sandy and Hurricane Isaac. Partially offsetting these catastrophe losses was $32.9 million in net favorable loss reserve development on prior accident years. The net favorable development was primarily attributable to our general liability, workers compensation and Syndicate 1200 property lines, partially offset by unfavorable development in our commercial multi-peril lines.
Included in losses and loss adjustment expenses for the year ended December 31, 2011 was $208.6 million in catastrophe losses resulting from the Japan and New Zealand earthquakes, storm activity in the United States and flooding in Australia and Thailand. Additionally, we recognized $9.3 million in losses under aggregate reinsurance covers. Partially offsetting these 2011 accident year losses was $3.4 million in net favorable loss reserve development on prior accident years. The net favorable development was primarily attributable to our general liability and workers compensation lines, partially offset by unfavorable development in our Syndicate 1200 property and liability lines, as well as our commercial multi-peril lines.
The following table summarizes the above referenced loss reserve development as respects to prior year loss reserves by line of business for the year ended December 31, 2013:
In determining appropriate reserve levels for the year ended December 31, 2013, we maintained the same general processes and disciplines that were used to set reserves at prior reporting dates. No significant changes in methodologies were made to estimate the reserves since the last reporting date; however, at each reporting date we reassess the actuarial estimate of the reserve for loss and loss adjustment expenses and record our best estimate. Consistent with prior reserve valuations, as claims data becomes more mature for prior accident years, actuarial estimates were refined to weigh certain actuarial methods more heavily in order to respond to any emerging trends in the paid and reported loss data. While prior accident years’ net reserves for losses and loss adjustment expenses for some lines of business have developed favorably in recent years, this does not imply that more recent accident years’ reserves also will develop favorably; pricing, reinsurance costs, legal environment, general economic conditions including changes in inflation and many other factors impact management’s ultimate loss estimates.
When determining reserve levels, we recognize that there are several factors that present challenges and uncertainties to the estimation of net loss reserves. Examples of these uncertainties include changes to the reinsurance structure and potential increases in inflation. Our net retained losses vary by product and they have generally increased over time. To properly recognize these uncertainties, actuarial reviews have given significant consideration to the paid and incurred Bornhuetter-Ferguson (“BF”) methodologies. Compared with other actuarial methodologies, the paid and incurred BF methods assign smaller weight to actual reported loss experience, with the greatest weight assigned to an expected or planned loss ratio. The expected or planned loss ratio has typically been determined using various assumptions pertaining to prospective loss frequency and loss severity. In setting reserves at December 31, 2013, we continued to consider the paid and incurred BF methods for recent years.
Our loss reserve estimates gradually blend in the results from development and frequency/severity methodologies over time. For general liability estimates, our own loss experience is not deemed fully credible for several years after the end of an accident year. We rely primarily on the BF methods during that period. For property business, our loss reserve estimates also blend in the results from development and frequency/severity methodologies over time. For property lines, in contrast to general liability estimates, we give greater weight to development methods starting at the end of the accident year where loss reporting and claims closing patterns settle more quickly.
In 2011, we entered into two reinsurance transactions with a special purpose reinsurance company which provided coverage through the issuance of two catastrophe bond transactions. The reinsurance transactions provide coverage for selected events. The initial catastrophe bond cover expired on December 31, 2012. The second catastrophe bond cover expired on December 31, 2013. In accordance with generally accepted accounting principles in the United States (“GAAP”), we are accounting for these covers as derivatives, and as such, present the financial statement impact in a separate line item - “Other reinsurance-related expenses”-in our Consolidated Statements of Income (Loss). Other reinsurance-related expenses totaled $19.2 million, $27.3 million and $5.9 million for the years ended December 31, 2013, 2012 and 2011, respectively. As management views these coverages as reinsurance protection, we treat the financial statement effects of these covers as ceded premium for the purposes of calculating our loss, expense and combined ratios.
Consolidated underwriting, acquisition and insurance expenses were $510.8 million, $464.5 million and $425.7 million for the years ended December 31, 2013, 2012 and 2011, respectively. The decrease in the consolidated expense ratio for 2013 as compared to 2012 was primarily attributable to reduced fixed costs as a percentage of earned premiums, partially offset by increased equity compensation expense due to the impact of the increase in our stock price on cash-settled equity awards. The increase in the consolidated expense ratio for 2012 as compared to 2011 reflects approximately $13.1 million of increased expense related to our investments in start-up operations abroad.
Consolidated interest expense was $20.2 million, $23.7 million and $22.1 million for the years ended December 31, 2013, 2012 and 2011, respectively. The decline in consolidated interest expense for the year ended December 31, 2013 as compared to 2012 was due to the redemption in November 2012 of the $118.6 million Capital Trust Securities with proceeds from the senior fixed rate notes, which bear a lower interest rate. The increase in interest expense for the year ended December 31, 2012 as compared to the same period in 2011 was primarily attributable to interest being accrued for both the Senior Notes (issued in September 2012) and $118.6 million of Capital Trust Securities prior to their redemption in November 2012.
Consolidated foreign currency exchange gains were $1.7 million for the year ended December 31, 2013 compared to foreign currency exchange losses of $4.3 million and $3.5 million for the years ended December 31, 2012 and 2011, respectively. The changes in the foreign currency exchange gains were due to fluctuations of the U.S Dollar, on a weighted average basis, against the currencies in which we transact our business.
The consolidated provisions for income taxes were $36.5 million, $14.4 million and $20.0 million for the years ended December 31, 2013, 2012 and 2011, respectively. The consolidated income tax provision represents the income tax expense associated with our operations based on the tax laws of the jurisdictions in which they operate. Therefore, the consolidated provision for income taxes represents taxes on net income for our United States, Ireland, Belgium, Brazil, Switzerland and the United Kingdom operations. The consolidated tax provision for the year ended December 31, 2013 was primarily attributable to our United States operations and was primarily the result of the realized investment gains. The consolidated tax provision for the year ended December 31, 2012 primarily represents taxes on net income from our operations in the United States and United Kingdom. For the year ended December 31, 2011, the tax provision generated by our operations based in the United States was partially offset by tax benefits for our operations based in the United Kingdom.
The decline in the expense ratio for the year ended December 31, 2013 as compared to the same period in 2012 was primarily attributable to the increase in earned premiums, without a corresponding increase in fixed costs. The increase in the expense ratio for the year ended December 31, 2012 as compared to the same period in 2011 was primarily attributable to declining earned premiums.
The decline in gross written and earned premiums for the year ended December 31, 2013 as compared to the same periods ended 2012 and 2011 was primarily due to reduced writings in our retail business and public entity units due to planned reductions as we exited unprofitable accounts and implemented underwriting initiatives, partially offset by increasing rates. Gross written premiums for our retail business declined to $75.6 million for the year ended December 31, 2013 compared to $98.7 million for the same period ended 2012. Gross written premiums for our public entity unit declined to $99.9 million for the year ended December 31, 2013 compared to $124.4 million for the same period in 2012. Partially offsetting these declines was increased gross written premiums in our surety business and commercial programs units, as these business units continue to expand.
Included in losses and loss adjustment expense for the year ended December 31, 2013 was $4.0 million in catastrophe losses for storm activity in the United States. Included in losses and loss adjustment expense for the year ended December 31, 2013 was $7.4 million related to current accident year large losses in our retail, commercial programs and public entity businesses. Additionally, included in losses and loss adjustment expenses was $1.1 million in net unfavorable loss reserve development on prior accident years, primarily attributable to $16.2 million of unfavorable development in general liability due to increases in claim severity and $2.0 million of unfavorable development in automobile liability, offset by favorable development of $9.5 million in workers compensation and $6.8 million of favorable development in short-tail lines.
Losses and loss adjustment expenses for the year ended December 31, 2013 included $16.5 million in catastrophe losses primarily attributable to $6.6 million resulting from the Canadian floods, $4.6 million from the European floods and $4.8 million from the German hailstorm. Prior year loss reserve development was negligible.
The increase in the expense ratio for the year ended December 31, 2013 as compared to the same periods in 2012 and 2011 was primarily attributable to the expenses for our Brazil operations continuing to out-pace earned premiums.
In 2013, we maintained our direct participation in Syndicate 1200 at 79%, consistent with our 2012 participation and up from the 69% participation in 2011. For the year ended December 31, 2013, the property division wrote $270.8 million in gross written premiums, compared to $253.6 million and $250.0 million for the same periods in 2012 and 2011, respectively. The increase in gross written premiums was primarily within the real estate owned and personal accident classes. The casualty division wrote $205.5 million, $172.5 million and $124.0 million of gross written premiums for the years ended December 31, 2013, 2012 and 2011, respectively. The increase in the casualty division was primarily attributable to growth within the general liability class. The specialty division wrote $81.1 million, $83.6 million and $54.1 million for the years ended December 31, 2013, 2012 and 2011, respectively. The decline in gross written premiums for 2013 as compared to 2012 was primarily attributable to reduced writings in the offshore energy classes as we reduced our exposure in the Gulf of Mexico and reduced writings in the yachts and hull classes due to reduced profitability. The aerospace division wrote $26.4 million, $23.3 million and $9.7 million in premiums for the years ended December 31, 2013, 2012 and 2011, respectively. We continue to grow the aerospace division, which began writing business in the first half of 2011.
Losses and loss adjustment expenses are reported net of losses ceded to the trade capital providers. The Syndicate 1200 segment reported no catastrophe losses for the year ended December 31, 2013. Included in losses and loss adjustment expense for the year ended December 31, 2013 were current accident year large losses of $4.4 million resulting from two onshore energy losses. The Syndicate 1200 segment had net favorable loss development of $6.2 million primarily attributable to $12.8 million of favorable development in various property classes, partially offset by $6.3 million of unfavorable development in liability lines associated with municipality business.
The decline in the expense ratio for the year ended December 31, 2013 as compared to the same period in 2012 was primarily attributable to reduced fixed costs as a percentage of earned premiums. The decrease in the expense ratio for the year ended December 31, 2012 as compared to the same period in 2011 was primarily attributable to both a change in business mix and a focus on reducing acquisiton costs.
Fee (expense) income, net represents fees and profit commission derived from the management of third party capital for our underwriting syndicate at Lloyd’s. The fee expense, net for the year ended December 31, 2013 was primarily due to the allocation of certain compensation expense not borne by the Syndicate. The increase in fee income, net for the year ended December 31, 2012 as compared to 2011 was primarily attributable to a reduction in the expenses related to the generation of the fee income.
Losses and loss adjustment expenses for the year ended December 31, 2013 included $10.5 million of unfavorable development in general liability lines resulting from asbestos exposure. The unfavorable development was driven by increasing defense costs in the primary book of business, higher than expected loss activity in the assumed book of business and commutations and settlements in 2013. Other run-off lines recorded $4.4 million in unfavorable development, including $2.0 million in unfavorable development in medical malpractice liability due to the loss of the New York Liquidation Bureau funding for structured annuity payments.
Losses and loss adjustment expenses for the year ended December 31, 2011 included $7.9 million in net unfavorable loss reserve development on prior accident years primarily due to $11.7 million of unfavorable development in general liability lines resulting from asbestos and environmental exposure, $4.6 million of unfavorable development on legacy reinsurance claims primarily related to Hurricanes Katrina, Rita and Wilma, and unfavorable development related to the unwinding of the workers compensation reserve discount. The unfavorable development was partially offset by favorable development on workers compensation including the collection of a contribution settlement from another insurer for a California indemnity claim and favorable development in other lines.
Cash provided (used) by operating activities can fluctuate due to timing difference in the collection of premiums and reinsurance recoveries and the payment of losses and expenses. For the year ended December 31, 2013 cash used by operating activities was $0.2 million compared to cash provided by operating activities of $30.5 million for the year ended December 31, 2012
Through a series of trusts, that are wholly-owned subsidiaries (non-consolidated), we issued trust preferred securities. The interest on the underlying debentures is variable with the rates being reset quarterly and subject to certain interest rate ceilings. Interest payments are payable quarterly. The debentures are all unsecured and are subordinated to other indebtedness. All are redeemable subject to certain terms and conditions at a price equal to 100% of the principal plus accrued and unpaid interest.
A summary of our outstanding junior subordinated debentures at December 31, 2013 is presented below:
Throughout 2013, 2012 and 2011, we had no preferred shares outstanding.
For the year ended December 31, 2013, our Board of Directors declared quarterly dividends in the amount of $0.60 per share ($0.59 per share adjusted for 10% stock dividend). Cash dividends paid for the year ended December 31, 2013 totaled $15.8 million. On February 18, 2014, our Board of Directors declared a quarterly cash dividend in the amount of $0.15 on each share of common stock outstanding. The dividend will be paid on March 17, 2014 to shareholders of record on March 3, 2014. The declaration and payment of future dividends to our shareholders is at the discretion of our Board of Directors and will depend upon our financial results, cash requirements, future prospects and other factors deemed relevant by our Board of Directors.
On February 18, 2011, our Board of Directors authorized the repurchase of up to $150.0 million of our common shares. The 2011 Repurchase Authorization supersedes the November 13, 2007 repurchase authorization which also had authorized the repurchase of up to $150.0 million of our common shares. On November 5, 2013, our Board of Directors authorized the repurchase of up to $150.0 million of our common shares. The 2013 Repurchase Authorization supersedes the 2011 Repurchase Authorization such that no further amounts could be repurchased under the 2011 Repurchase Authorization. These shares are being held as treasury shares in accordance with the provisions of the Bermuda Companies Act 1981. As of December 31, 2013, availability under the 2013 Repurchase Authorization for future repurchases of our common shares was $143.6 million.
Our insurance and reinsurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants and fund operating expenses. During the year ended December 31, 2013, cash flow used by operations was $0.2 million. Based on current premium volumes and other measures of capital deployed in our business, we determined we had excess capital and, therefore, returned capital to our shareholders through the share buy-back program and through dividend payments to our shareholders. We believe our liquidity generated from operations and, if required, from our investment portfolio, will be sufficient to meet our obligations for the foreseeable future. We believe we have access to various sources of liquidity including cash, investments and the ability to borrow under our revolving credit facility. Additionally, we continue to have access to the debt and equity markets, though we currently do not foresee needing access to these sources of capital.
We invest in the debt securities markets, which exposes us to credit risk. As a consequence of extending credit and/or carrying investment positions, we have exposure to credit risk arising from the uncertainty associated with a financial instrument obligor’s ability to make timely principal and/or interest payments. We attempt to mitigate this risk by limiting credit concentrations, diversification and frequently monitoring the credit quality of issuers and counterparties.
Additional information relating to our investment strategy and credit risk is included under Item 7A, “Quantitative and Qualitative Disclosures about Market Risk”.
We have committed to invest up to a total of $185.0 million in a series of private equity related limited partnerships. As of December 31, 2013, we have a remaining obligation to the partnerships to invest up to an additional $35.7 million, which can be called at any time. We have not recorded this commitment in our consolidated financial statements. The investment will be recorded at such time as the capital partnership requires the additional investment. Additionally, we have not recorded the liabilities for our operating leases in our consolidated financial statements.
Other than as described in the immediately preceding paragraph, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K at December 31, 2013.
Our estimated contractual obligations and commitments as of December 31, 2013 were as follows:
(3) Interest only on Floating Rate Loan Stock through 2034. Interest calculated based on the rate in effect at December 31, 2013. Principal due beginning November 2034.
(4) Purchase obligations consist primarily of software, hardware and equipment servicing and software licensing fees.
Following is a summary of gross and net loss reserves we recorded by line of business as of December 31, 2013 and 2012:
accident year, at which time we begin to assign weight to the paid and incurred BF methods depending on the line of business being evaluated. The BF methods compute IBNR through a blend of the expected loss ratio method and traditional loss development methods. The BF methods estimate IBNR for an accident year as the product of expected losses (earned premium multiplied by an expected loss ratio) plus an expected percentage of unreported losses. The expected percentage of unreported losses is derived from age-to-ultimate loss development factors that result from our analyses of loss development triangles. As accident years mature to the point at which the reported loss experience is more credible, we assign increasing weight to the paid and incurred loss development methods.
For long-tail lines such as general liability and automobile liability, the starting point for determining ultimate losses is initially the expected loss ratio method. The time lag for reporting claims is greater in liability lines of business than it is in short-tail lines. Facts and information are frequently not complete at the time case reserves are established, and because protracted litigation is sometimes involved potentially creating additional uncertainty in final settlement amounts, case reserves alone are an insufficient measure of the ultimate loss costs. Due to the variability in the timing of receipt and completeness of case reserve data, loss experience is not deemed fully credible for several years. At the end of the accident year, we rely primarily on the BF methods and continue to rely on those methods for several years. We assign greater credibility to the paid and incurred development methods as the data matures.
Each business segment is analyzed individually, with development characteristics for each short-tail and long-tail line of business identified and applied accordingly. In comparing loss reserve methods and assumptions used at December 31, 2013 as compared with methods and assumptions used at December 31, 2012, management has not changed or adjusted methodologies or assumptions in any significant manner.
Major factors contributing to uncertainty in loss reserve estimates for general liability include reporting lags (i.e., the length of time between the event triggering coverage and the actual reporting of the claim), the number of parties involved in the underlying tort action, events triggering coverage that are spread over multiple time periods, the inability to know in advance what actual indemnity costs associated with an individual claim will be, the potential for disputes over whether claims were reasonably foreseeable and intended to be covered at the time the contracts were underwritten and the potential for mass tort claims and class actions. Generally, claims with a longer reporting lag time are characterized by greater inherent risk of uncertainty.
Examples of loss and LAE risk factors associated with general liability claims that can change over time and result in adjustments to loss reserves include, but are not limited to, the following:
Changes in the propensity to sue, in general and with specificity to particular issues
Shifts in law suit mix between U.S. federal and state courts
For asbestos and environmental claims, we supplement our traditional loss forecasting methods with additional approaches that attempt to capture the risk characteristics of these insureds and the claimants involved.
Syndicate 1200 loss reserves are analyzed quarterly by internal staff. Additionally, we employ an independent actuary to conduct a detailed review of loss reserves annually. Management’s estimate of reserves is based on the internal study. The external study is completed to support the actuarial opinion for Lloyd’s reporting.
We use several approaches and actuarial techniques to project gross and net loss reserves. For property lines of business, we review our loss reserves considering the underlying claims. We utilize paid and incurred loss development as our primary methods for determining ultimate losses. Additionally, we consider expected loss ratios, pricing trends and any other variations in the business underwritten, including changes in underlying terms and conditions. Catastrophic claim liabilities and other large losses are inherently more volatile than attritional losses; therefore, we need to utilize other loss forecasting methodologies. For known catastrophic claims, we initially rely on industry estimates and information from third party modeling software to determine our exposure. As catastrophic events mature, specific claim information we receive is used to refine our initial loss estimate. After approximately four to six months from the date of the catastrophic event, our reported losses relative to the event are assigned significant credibility. However, it may be several years before ultimate loss amounts are fully known as disputes over policy coverage or the relevant law governing a claim cause uncertainty in the estimation of outcomes. The observed large loss patterns are subsequently adjusted by changes in underlying exposures and risk characteristics.
We perform our loss reserve analysis on a syndicate basis, which represents 100% of the business underwritten by the syndicate. We utilize trade reinsurance to cede a proportion of its premium income and incurred losses to trade reinsurers. The percentage of the cession differs for each underwriting year of account. The reinsurers’ share of provisions for claims is based on calculated amounts of outstanding claims and projections for IBNR, net of estimated unrecoverable amounts. The syndicate will evaluate the reinsurance program in place for the class of business, the claims experience for the year and the security rating of the reinsurance companies involved. This evaluation, along with other factors and considerations, is used to determine trade reinsurer participation in future years.
Commercial multiple peril lines insure a combination of property and liability exposures, and therefore, include both short and long-tail coverages. Property coverage claims are generally resolved in a short period of time, while liability coverage claims generally require more time to resolve. The risk of fluctuation in loss reserves for this line is predominately associated with liability coverage, with risk factors similar to other general liability lines described above.
Because commercial multiple peril lines involve both short-tail and long-tail coverages, we give weight to different methodologies in deriving estimated loss reserves based on the coverage being evaluated. In general, paid and incurred loss development methods are used to forecast property losses. For liability losses, due to the Claims and Book of Business risk factors described in the General Liability section above, we use several loss reserving methods to capture the development characteristics associated with these lines of business. Paid and incurred loss development, paid and incurred BF methods and a loss frequency/severity method are used in deriving estimated loss reserves. In addition to these approaches, which are used across most commercial multiple peril categories of business, we also consider additional analytic measures in deriving loss reserve estimates for certain product lines with differing characteristics.
In addition to the indications of the actuarial methods, we consider additional analytic measures based upon the Claims and Book of Business risk factors noted above in deriving our loss reserve estimate.
Concurrently, underwriting teams employ a market share approach as well as perform a thorough contract by contract analysis to identify potential changes to the expected loss estimates including IBNR by contract. The results of this initial process are updated when additional information is available. This information comes in the form of publicly available announcements, informal contact with brokers and/or clients, submission data and formal claim notices. As catastrophic events mature and reporting loss methods become more credible (usually six to twelve months after the event) actuarial methods implementing historical patterns can be assigned more credibility. In evaluating the loss estimates for catastrophic events, we use internal databases to establish projected reporting patterns and payment patterns. Industry patterns from the Reinsurance Association of America (“RAA”), an insurance industry organization, are also employed.
The following discussion includes disclosure of possible variations from current estimates of loss reserves due to a change in certain key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among other key assumptions or among lines of business. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for our reserves in total. The estimated variations in reserves due to changes in key assumptions discussed below are a reasonable estimate of possible variations that may occur in the future, likely over a period of several calendar years. It is important to note that the variations discussed herein are not meant to be a worst or best case scenario, and therefore, it is possible that future variations may be more than amounts discussed below.
Similar to general liability, commercial multiple peril reserves are affected by reported loss development pattern assumptions. Recorded gross reserves for commercial multiple peril business were $203.7 million as of December 31, 2013. If the development patterns underlying our net reserves for this line of business change by 10%, the estimated net reserve could change by $10.0 million, in either direction.
Recorded gross reserves for commercial auto liability were $172.6 million as of December 31, 2013. A key assumption for commercial lines auto liability is the annual loss cost trend, particularly the severity trend component of loss costs. A 3% change in assumed annual severity is within the range of our historical experience, and that management considers possible. A 3% change in assumed annual severity could change the estimated net reserve by $25.0 million, in either direction.
Recorded gross reserves for Syndicate 1200 were $777.0 million as of December 31, 2013. Estimation of International liability reserves are subject to late emergence and mix shifts between smaller, more routine claims and larger, more complex claims. International property reserves are analyzed by the characteristics of the underlying exposures. Property loss reserves are characterized by relatively short periods between occurrence, reporting, determination of coverage and ultimate claims settlement. These property loss reserves tend to be the most predictable. Catastrophic loss reserves tend to exhibit more volatility due to the nature of the underlying loss event which may cause delays and complexity in estimating ultimate loss exposure.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate loss development patterns, plaintiffs’ expanding theories of liability, the risks inherent in major litigation and inconsistent emerging legal outcomes. Furthermore, over time, insurers, including Argo Group, have experienced significant changes in the rate at which asbestos claims are brought, claims experience of particular insureds and value of claims, making predictions of future
exposure from past experience uncertain. For example, in the past, insurers in general, including Argo Group, have experienced an increase in the number of asbestos-related claims due to, among other things, plaintiffs’ increased focus on new and previously peripheral defendants and an increase in the number of insureds seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to use bankruptcy proceedings, including “pre-packaged” bankruptcies, to accelerate the funding and amount of loss payments by insurers. In addition, some policyholders continue to assert new classes of claims for coverages to which an aggregate limit of liability may not apply. Further uncertainties include insolvencies of other insurers and reinsurers, delays in the reporting of new claims by insurers and reinsurers and unanticipated issues influencing our ability to recover reinsurance for asbestos and environmental claims. Management believes these issues are not likely to be resolved in the near future.
After reviewing the output from various loss reserving methodologies, management selects its best estimate of reserves. Management believes that the aggregate loss reserves at December 31, 2013 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. As of December 31, 2013, we recorded gross loss reserves of $3,230.3 million and loss reserves net of reinsurance of $2,107.6 million. Although our financial reports reflect management’s best estimate of reserves, it is unlikely that the final amount paid will exactly equal management’s best estimate. In order to provide an indication of the variability in loss reserve estimates, we develop reserve ranges by evaluating the variability implied by the results of the various methods and the impact of changing the assumptions and factors used in the loss reserving process.
We estimate our range of reserves, net of reinsurance, at approximately $1,915 million to $2,380 million as of December 31, 2013. In determining this range, we evaluated the variability of the loss reserves for each of our major operating segments, comprising both ongoing operations and runoff businesses. Our estimated range does not make a specific provision for sources of unknown or unanticipated correlated events such as potential sources of liability not anticipated at the time coverage was afforded, such as asbestos. These events in combination with other events which may not be contemplated by management in developing our range may cause reserves to develop either more or less favorably than indicated by assumptions that management considers reasonable. This means that the range of reserve values does not represent the range of all possible favorable or unfavorable reserve outcomes, and actual ultimate paid losses may fall outside this range. No one risk factor has been isolated for the purpose of performing a sensitivity or variability analysis on that particular risk factor.
In establishing our best estimate for reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts, legislatures in the recent past and possibility of similar interpretations in the future, particularly with regard to asbestos and environmental claims, additional loss reserves may develop in future periods. These potential increases cannot be reasonably estimated at the present time. Any increases could have an adverse impact on future operating results, liquidity, risk-based capital ratios and ratings assigned to our insurance subsidiaries by the nationally recognized insurance rating agencies.
Valuation of Investments. Our investments in fixed maturities and stocks are classified as available-for-sale and reported at fair value under GAAP. Changes in the fair value of investments classified as available-for-sale are not recognized in income during the period, but rather are recognized as a separate component of shareholders’ equity until realized. Fair values of these investments are estimated using prices obtained from third party pricing services, where available. For securities where we are unable to obtain fair values from a pricing service or broker, fair values are estimated using information obtained from investment advisors. Management performed several processes to ascertain the reasonableness of investment values included in the consolidated financial statements at December 31, 2013, including i) obtaining and reviewing internal control reports for our accounting service providers that obtain fair values from third party pricing services, ii) discussing with our investment managers their process for reviewing and validating pricing obtained from outside services and obtained values for all securities from our investment managers and iii) comparing the security pricing received from the investment managers with the prices used in the consolidated financial statements and obtained additional information for variances that exceeded a certain threshold. As of December 31, 2013, investments classified as available-for-sale for which we did not receive a fair value from a pricing service or broker accounted for less than 1% of our investment portfolio. The actual value at which such securities could be sold or settled with a willing buyer or seller may differ from such estimated fair values depending on a number of factors including, but not limited to, current and future economic conditions, the quantity sold or settled, the presence of an active market and the availability of a willing buyer or seller.
Realization of deferred tax assets is dependent upon our generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in the carryback period, which is generally two years for net operating losses and three years for capital losses. At December 31, 2013, we had a total net deferred tax asset of $27.5 million prior to any valuation allowance. Management has concluded that a valuation allowance is required for a portion of the tax effected net capital loss carryforward of $29.8 million generated from the sale of PXRE Reinsurance Company, and a full valuation allowance is required for the tax effected net operating loss carryforward of $18.8 million from PXRE Corporation and for the tax effected net operating loss carryforward of $1.0 million from ARIS Title Insurance Corporation (“ARIS”). The capital loss carryforward generated from the sale of PXRE Reinsurance Company expired December 31, 2013. Of the PXRE loss carryforwards, $17.2 million will expire if not used by December 31, 2025 and $1.5 million will expire if not used by December 31, 2027. Of the ARIS loss carryforward, $0.2 million will expire if not used by December 31, 2027, $0.4 million will expire if not used by December 31, 2028 and $0.4 million will expire if not used by December 31, 2029. The valuation
allowances have been established as Internal Revenue Code Section 382 limits the utilization of net operating loss and net capital loss carryforwards following an ownership change. Accordingly, a valuation allowance of $56.2 million is required as of December 31, 2013. The loss carryforwards available to use per year are $2.8 million as required by Internal Revenue Code Section 382. During the year ended December 31, 2013, the valuation allowance was reduced by $1.0 million pertaining to the use of the PXRE and ARIS loss carryforwards, was increased by $0.6 million pertaining to the Malta operations and was increased by $4.1 million pertaining to the Brazil operations. The net deferred tax liability after the valuation allowance is $28.7 million at December 31, 2013. Management regularly evaluates the recoverability of the deferred tax assets and makes any necessary adjustments to them based upon any changes in management’s expectations of future taxable income.
On October 1, 2013, the resulting fair values of the reporting units were in excess of the carrying value, including goodwill, of the reporting units. Accordingly, management did not perform Step 2. However, a 38% decline in the fair value of the Excess and Surplus Lines reporting unit, 21% decline in the fair value of the Commercial Specialty reporting unit or 16% decline in the fair value of the Syndicate 1200 reporting unit would have resulted in the carrying values of these reporting units being in excess of their respective fair values, resulting in the need to perform Step 2, which could have resulted in a material impairment to our goodwill. Any decline in the fair value of these reporting units could result in the carrying value of the reporting unit being in excess of fair value, triggering Step 2 of the impairment testing model. Step 2 could result in an impairment of goodwill.
While management believes the estimates and assumptions are reasonable in determining the fair value of reporting units, it is possible a material change could occur. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, we may be required to perform Step 2 in future periods and impairment of goodwill and/or indefinite-lived assets could result. We cannot predict future events that might impact the fair value of reporting units and goodwill impairment. Such events include, but are not limited to, increased competition in insurance markets and global economic changes.