The principal offices of Seneca are located in space leased by Seneca in New York, New York. The lease covers approximately 21,500 square feet at 160 Water Street. The term of the lease ends June 30, 2007.
The most significant accounting estimates relate to the Company’s reserves for unpaid losses and LAE. Unpaid losses and LAE include reserves for unpaid reported losses and LAE and for IBNR losses. The reserves for unpaid reported losses generally represent the estimated ultimate cost of events or conditions that have been reported to the Company. IBNR reserves include estimates of losses incurred but not reported to the Company, including estimates of expenses to settle claims, such as legal and other fees and the general expenses of administering the claims adjustment process.
With regard to case reserves, the Company is notified of insured losses, and claims personnel or independent claims adjusters hired by the Company initially set up case reserves for the estimated amount of settlement, if any. The estimate reflects the judgment of claims personnel based on the parameters of coverage provided in the insurance policy, general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel, with the goal of setting the reserve at the ultimate expected loss amount as soon as information becomes available.
Asbestos is the most significant and difficult mass tort for the insurance industry in terms of claim volume and dollar exposure. The litigation environment has become increasingly adverse. Plaintiffs often are able to choose from a number of potential venues to bring an action in the court that they expect will be most advantageous to their claims. Many of the lawsuits are filed in a small number of plaintiff-oriented jurisdictions, where significant verdicts historically have been rendered against commercial defendants. Tort reform in certain jurisdictions initially resulted in increased filings by plaintiffs seeking to avoid the potential effective date of the reform legislation in 2003. In general, the number of new claims filed in 2004 declined slightly, but it is too soon to predict whether this will constitute a trend in new filings. Management believes that the insurance industry has been adversely affected by judicial interpretations that have had the effect of maximizing insurance recoveries for asbestos claims, from both a coverage and liability perspective. Even when these claims are resolved without loss payment, as a large portion of them are, significant costs are incurred to defend the claims. Generally, only policies underwritten prior to 1986 have potential asbestos exposure since most policies underwritten after that date contain an absolute asbestos exclusion.
Over the past few years, the industry has experienced an increase in the number of asbestos claimants over prior years, including claims by individuals who do not appear to be impaired by asbestos exposure. It is generally expected throughout the industry that this trend will continue. The reasons for this evident increase are many: more intensive advertising by lawyers seeking additional claimants; increased focus by plaintiffs on new and previously peripheral defendants; an increase in the number of entities seeking bankruptcy protection; and a rush to file claims before potential implementation of proposed legislative reforms. To date, this continued flow of claims has forced 71 manufacturers and users of asbestos products into bankruptcy. These bankruptcies have, in turn, aggravated both the volume and the value of claims against viable asbestos defendants. Accordingly, there is a high degree of uncertainty with respect to future exposure from asbestos claims, both in identifying which additional insureds may become targets in the future and in predicting the total number of asbestos claimants.
The Company’s asbestos exposure is related mostly to insureds that are peripheral defendants, including a mix of manufacturers, distributors and installers of asbestos-containing products, as well as premise owners. For the most part, these insureds are defendants on a regional, rather than a nationwide, basis. As the financial assets and insurance recoveries of traditional asbestos defendants have been depleted, plaintiffs are increasingly focusing on these peripheral defendants. The Company is experiencing an increase in asbestos claims on its policies.
As of December 31, 2004, the Company had gross unrealized losses on available-for-sale fixed income and equity investments of $67.5 million and no other than temporary impairments were recorded for the year ended December 31, 2004. For the years ended December 31, 2003 and 2002, other than temporary impairments amounted to $13.8 million and $0.3 million, respectively. For a more detailed discussion of the Company’s gross unrealized losses on available-for-sale securities, see Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Amounts recoverable from reinsurers are initially estimated in conjunction with the establishment of reserves for unpaid losses and LAE. These amounts may be adjusted as actual case reserves are recorded and reinsured claims are settled. The ceding of risk to reinsurers does not relieve the operating companies of their primary obligation to policyholders as the direct insurer. Accordingly, the Company is exposed to the risk that any reinsurer may be unable, or unwilling, to meet the obligations assumed under its reinsurance agreements. Management attempts to mitigate this risk by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have credit ratings and statutory surplus above certain levels.
Although realization is not assured, management believes the recorded deferred tax assets are fully recoverable based on estimates of the future profitability of Crum & Forster’s taxable entities and current forecasts for the periods through which losses may be carried forward.
The Company is a national commercial property and casualty insurance company with a focused underwriting strategy, targeting specialty classes of business and overlooked market opportunities. Operating through its home office and regional branch network, the Company writes a broad range of commercial coverage, including workers’ compensation, general liability, property, commercial automobile, commercial multi-peril and surety. The Company generally conducts business on a brokerage basis through more than 1,000 producers located throughout the United States. The Company’s two largest producers accounted for approximately 14% and 6% of gross premiums written for the year ended December 31, 2004.
The Company’s objective is to expand opportunistically into classes of business or market segments that are consistent with its underwriting expertise and have the potential to generate an underwriting profit. Management believes the Company’s ability to identify and react to changing market conditions provides it with a competitive advantage. Based on the experience and underwriting expertise of management, the Company seeks to write new lines of business and expand existing classes of business based on market conditions and expected profitability. The Company offers insurance products designed to meet specific insurance needs of targeted insured groups and underwrites specific types of coverage for markets that are generally underserved by the industry.
The profitability of property and casualty insurance companies is primarily determined by their underwriting results and investment performance. Underwriting results are the net result of a company’s premiums earned and amounts paid, or expected to be paid, to settle insured claims and policy acquisition costs and other underwriting expenses. The insurance business is unique in that premiums charged for insurance coverage are set without certainty of the ultimate claim costs to be incurred on a given policy. This requires that liabilities be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, there can be no assurance that actual liabilities will not exceed recorded amounts or premiums received. The ultimate adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural and man-made disasters, regulatory measures and court decisions that define and expand the extent of coverage. Insurance premium prices are also influenced by available insurance capacity or the industry’s willingness to deploy capital to cover each insurable risk.
Premiums collected are invested until funds are required to pay settled claims. Insurance company investment portfolios generally must provide a balance among total return, capital preservation and liquidity in order to generate sufficient funds for payment of claims as they are settled. The Company follows a long-term, value-oriented investment philosophy, with the goal of optimizing investment returns viewed on a total return basis, without reaching for yield, while maintaining sensitivity to liquidity requirements. The Company attempts to protect its capital from loss. Management believes that investing in debt and equity securities selling at prices below intrinsic value better protects the Company’s capital.
Management measures the results of operations by monitoring certain indicators of growth and profitability. Growth is generally measured in terms of gross premiums written. Management further monitors growth in its gross premiums written in terms of its rate of retention of existing insureds, increases or decreases in the pricing of renewed policies and the growth in new business premiums.
The combined ratio expresses underwriting results as a percentage of premiums earned and generally comprises two components: the loss ratio, which is the percentage of losses and LAE to premiums earned, and the expense ratio, which is the percentage of the sum of policy acquisition costs and other underwriting expenses to premiums earned. A combined ratio less than 100% indicates an underwriting profit; a combined ratio greater than 100% indicates an underwriting loss.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural and man-made disasters (for example, hurricanes, earthquakes and terrorism), interest rates, state regulations, court decisions and changes in the law. Commencing in mid-2000 and through mid-2003, insurers generally achieved significant rate increases and improved terms and conditions. In 2003, however, market capacity expanded, particularly for property risks. In the fourth quarter of 2003 and through 2004, property risks generally were written at or below expiring prices, and price increases in casualty lines slowed considerably. Market competition intensified throughout 2004, particularly in the third and fourth quarters. Renewal pricing in the Company’s casualty lines increased by approximately 1% overall in 2004, but decreased by approximately 2% and 5% in the third and fourth quarters of 2004, respectively. Renewal pricing in the Company’s property lines declined by approximately 5% in 2004.
For the year ended December 31, 2004, the Company reported gross premiums written of $1,139 million, representing an increase of $34.8 million, or 3.2%, over the year ended December 31, 2003. The growth in gross premiums written was primarily due to an increase in the renewal retention rate from approximately 60% in 2003 to approximately 65% in 2004, partially offset by a decrease in new business of approximately 22%. Renewal retention rates increased despite the softening market, particularly in the property lines, as a result of the maturing of the Company’s book of business. New business declined as the market has softened and competition for new business, particularly from higher rated companies, has intensified. Overall, pricing remained relatively stable in 2004.
For the year ended December 31, 2003, the Company reported gross premiums written of $1,104.2 million, representing an increase of $205.8 million, or 22.9%, over the year ended December 31, 2002. The growth in gross premiums written was primarily due to the combined impact of an increase in the renewal retention level of 18 percentage points, price increases on renewal policies of approximately 10% and an increase in new business of approximately 16%. The 2003 growth in new business was attributable, in part, to the Company’s significant expansion of California workers’ compensation business.
For the year ended December 31, 2003, gross premiums written in casualty lines increased by $158.6 million, or 28.7%, as compared to the year ended December 31, 2002. This increase was primarily due to increases in the renewal retention rate, pricing and new business in all casualty business lines, including the expansion of operations in California.
For the year ended December 31, 2004, net premiums written increased by $27.5 million, or 3.1%, as compared to the year ended December 31, 2003. This increase was in line with the growth in gross premiums written. For the year ended December 31, 2003, net premiums written increased by $221.3 million, or 33.1%, as compared to the year ended December 31, 2002. This increase was generally in line with the growth in gross premiums written after giving effect to ceded premiums related to corporate aggregate reinsurance of $32.3 million in 2002.
The decline in percentage of net premiums written to gross premiums written from 2002 to 2004 in the property line was primarily the result of the purchase of increased catastrophe reinsurance coverage and reinstatement premiums associated with the Florida hurricanes in 2004. The increase in percentage of net premiums written to gross premiums written from 2002 to 2004 in the general liability and commercial automobile lines is primarily the result of the discontinuation of certain fully ceded business programs.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2004, premiums earned increased by $138.8 million, or 18.1%, as compared to the year ended December 31, 2003. The larger increase in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the increased premiums written in the latter part of 2003.
The Company’s losses and LAE reflect the impact of corporate aggregate reinsurance, including the amortization of deferred gain on retroactive reinsurance and cessions to prospective reinsurance contracts. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business-Reinsurance” and Note 2 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The adverse development before corporate aggregate reinsurance in calendar year 2003 of $132.2 million (17.2 percentage points) was primarily due to strengthening of asbestos reserves. Based on its internal actuarial reserve review, the Company strengthened its asbestos, environmental and other latent reserves by $153.6 million, of which asbestos liabilities accounted for $149.8 million. These reserve increases were partially offset by favorable non-latent development of $53.1 million in accident year 1998 and prior and $34.9 million in accident year 2002, primarily in the workers’ compensation and commercial automobile lines. Adverse development of $56.8 million was also recognized for accident year 2001 in all liability lines.
The adverse development before corporate aggregate reinsurance in calendar year 2002 of $26.6 million (4.2 percentage points) includes $67.5 million for asbestos liabilities, which was driven by increases in several large asbestos accounts. This adverse development was partially offset by favorable non-latent development of $52.2 million in accident years 1998 and prior, primarily affecting the general liability and commercial multi-peril lines.
The workers’ compensation loss ratio decrease of approximately 11.9 percentage points from accident year 2002 to 2004 included the favorable impact of substantial price increases in 2003. The Company has expanded its workers’ compensation writings in California since 2000. Management believes that this business will continue to generate a profit; however, Crum & Forster’s limited historical experience in California adds an additional measure of uncertainty to the Company’s loss and LAE ratio.
The 2004 accident year commercial automobile loss ratio of 67.6% is lower than the accident year 2002 loss ratio of 78.6% as a result of price increases in the Company’s commercial automobile line of business.
The Company’s underwriting expense ratios, before and after adjustments for corporate aggregate reinsurance, are summarized as follows:
Underwriting expense ratio, as adjusted for the impact of corporate aggregate reinsurance
The Company’s policy acquisition expense ratio increased from 12.5% in 2002 to 12.8% in 2003 and to 13.6% in 2004 primarily due to lower amounts of ceding commissions paid by reinsurers.
Realized investment gains were $79.5 million in 2004, $268.2 million in 2003 and $41.5 million in 2002. Favorable economic conditions, primarily in the U.S. bond markets, resulted in significant realized investment gains in 2003. Investment results in 2003 also benefited from $40.7 million of realized investment gains generated from the sale of securities to an affiliate. For further information on this transaction, see Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. Included in realized investment gains in 2003 were $13.8 million of losses related to other than temporary impairments. No other than temporary impairments were recorded in 2004.
Pre-tax equity in earnings of investees was $19.2 million and $2.4 million in 2004 and 2003, respectively. The increase in equity in pre-tax earnings of investees in 2004 of $16.8 million, as compared to 2003, was primarily attributable to higher earnings from Northbridge Financial Corporation (“Northbridge”), which was purchased in the second quarter of 2003. Northbridge contributed $18.1 million and $3.2 million to the Company’s pre-tax equity in earnings of investees in 2004 and 2003, respectively.
In July 2004, as an economic hedge against a decline in the U.S. equity markets, the Company executed short sales totaling approximately $200 million of Standard & Poor’s Depositary Receipts (“SPDRs”). Simultaneously, the Company purchased two-year S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs to $40 million. The cost of the Options was $6 million. Both the obligations to purchase the SPDRs and the Options are carried at fair value in the consolidated financial statements and changes in the fair value of both the SPDRs and the Options, totaling a loss of $15.2 million in 2004, are recorded in realized investment gains. The Company also incurs investment expense in an amount equal to the dividend earnings on the SPDRs sold. Investment expense of $2.5 million relating to this transaction was recorded for the year ended December 31, 2004.
Included in realized investment gains are certain gains on sales of investments in Fairfax affiliates. For further information on realized investment gains on sales of investments in affiliates, see Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The effective tax rate was 31.7%, including income taxes on equity in earnings of investees, for the year ended December 31, 2004. The difference between the Company’s effective tax rate and the statutory rate of 35% was primarily due to the benefit of dividends received deductions. The effective tax rate approximated the federal statutory income tax rate of 35% for the years ended December 31, 2003 and 2002.
The ability of the Company’s insurance subsidiaries to pay dividends depends, among other things, on such subsidiaries having positive statutory earned surplus. The Company’s principal insurance subsidiaries are US Fire and North River. On March 29, 2004, US Fire paid a cash shareholder dividend of $80 million. Crum & Forster subsequently paid cash shareholder dividends to Fairfax totaling $61.5 million. The remaining amount was used to pay corporate expenses including satisfaction of an obligation to Fairfax in the amount of $7.9 million. North River did not pay dividends in 2004, as it did not have positive statutory earned surplus at December 31, 2003. Based on December 31, 2004 earned surplus, US Fire had capacity to pay ordinary dividends in 2005 in the amount of $88.5 million and North River had capacity to pay ordinary dividends in 2005 of $5 million. As of December 31, 2004, US Fire had statutory earned surplus of $173.1 million and North River reported statutory earned surplus of $5 million.
Pursuant to a non-interest bearing standby credit agreement between Fairfax and the Company, under certain circumstances the Company has the ability to borrow up to $40 million from Fairfax to meet certain corporate obligations. Borrowings under this agreement, if any, bear no interest and are due in June 2018. Through December 31, 2004, there have been no borrowings under this agreement.
Cash used in financing activities, which relates principally to holding company activities, was $62.5 million in 2004, primarily as the result of $61.5 million of dividends paid to Fairfax. Cash provided by financing activities was $0.4 million and $0.3 million for 2003 and 2002 respectively. Financing cash flows in 2003 were the result of offering costs from the issuance of the senior notes, which were not paid until 2004. A capital contribution of $0.3 million was received from Fairfax in 2002.
At Crum & Forster’s insurance subsidiaries, cash provided by operating activities primarily consists of premium collections, reinsurance recoveries and investment income. Cash provided from these sources is generally used for payment of losses and LAE, policy acquisition costs, operating expenses, ceded reinsurance premiums, income taxes and shareholder dividends, when permitted. Management believes that, for the foreseeable future, cash flows from operations at its insurance subsidiaries will be sufficient to meet their operating liquidity needs.
Cash provided by operating activities amounted to $125.3 million in 2004 and $387.5 million in 2003 and cash used by operating activities amounted to $110.5 million for 2002. The principal reasons for the decline in cash flows from operations in 2004 were $234.5 million in proceeds received in 2003 as a result of the commutation of two reinsurance treaties (an additional $39.5 million in proceeds from one such commutation was received in 2004) and in 2004, higher net losses paid (partially attributable to higher catastrophe losses in 2004), partially offset by growth in premium collections. Cash used in operating activities improved by $497.9 million in 2003 as a result of the two aforementioned commutations, growth in gross premiums written, lower ceded premiums under the corporate aggregate reinsurance program and higher reinsurance and other recoveries.
Cash used in investing activities during 2004 was $1,715.5 million primarily as a result of the reinvestment of over $1 billion of cash and cash equivalents into higher yielding, longer-term investments in the first quarter of 2004. Cash provided by investing activities in 2003 and 2002 was $1,484.9 million and $45.7 million, respectively. In 2003, sales of fixed income securities generated proceeds, net of purchases, of $1,501.8 million, as compared to $105.8 million in 2002 as the result of favorable economic conditions, primarily in the U.S. bond markets, in 2003. The proceeds from such sales were invested in low-yielding short-term investments until reinvested in the first quarter of 2004.
The Company’s investment portfolio has exposure to credit risk primarily related to fixed income securities. Management attempts to control this exposure by emphasizing investment grade credit quality in the fixed income securities purchased. Management believes that this concentration in investment grade securities reduces the Company’s exposure to credit risk to an acceptable level. As of December 31, 2004 and 2003, 95.6% and 74.9% of the Company’s fixed income portfolio consisted of securities rated investment grade, respectively. The higher proportion of investment grade securities at December 31, 2004 was due primarily to the reinvestment of more than $1 billion of cash and cash equivalents principally in U.S. Treasury securities in March 2004. Fixed income securities and cash and cash equivalents of $292.4 million and $171.8 million were on deposit with various state regulatory authorities at December 31, 2004 and 2003, respectively, as required by insurance laws.
Estimates of future payments pursuant to the Company’s contractual obligations as of December 31, 2004 are summarized as follows:
The liability for unpaid losses and LAE includes reserves for unpaid reported losses and LAE and for IBNR losses. The amounts shown above represent management’s best estimate of the expected timing of payments for losses and LAE given information currently available. Actual results may differ significantly from these estimates. For additional information on the Company’s unpaid losses and LAE, see “Item 1. Business-Reserves”, “Item 1. Business-Risk Factors” and “-Critical Accounting Policies and Estimates-Unpaid losses and LAE”.
The health care and life insurance benefit obligations represent management’s best estimate of the ultimate payments required to provide such benefits and such payments differ from the obligation recognized on the balance sheet by approximately $1.7 million. The amounts included above for such obligations represents management’s best estimate of the timing of future payments. Actual payments may differ significantly from these estimates. Although the Company provides various benefit plans, programs and arrangements to its employees, the Company has reserved the right to amend, modify or terminate these plans, programs or arrangements at any time, subject to the terms and conditions of such plans, programs or arrangements and applicable law. For more information on the Company’s post-retirement benefit plans, see Note 11 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The incentive and bonus plans included herein are compensation arrangements for certain of the Company’s executives. These agreements are discussed further in “Item 11. Executive Compensation”. The amounts shown above represent management’s best estimate of the liabilities under these plans. Actual payments could be materially different from those estimates.
Unrealized losses that are deemed other than temporary are charged to operations. Recognition of impairment losses for declines in value of fixed income and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, current and expected future market and economic conditions, the impact of issuer-specific events, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price. For fixed income investments with unrealized losses due to market conditions or industry-related events, management also considers the Company’s ability and intent to hold the investments to maturity, or for a period of time sufficient to allow a market recovery, in the process of evaluating whether a security with an unrealized loss has suffered an other than temporary decline.
Investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company, are carried under the equity method of accounting. For all other investments, the Company determines if it exercises significant influence based upon its ownership of shares without consideration of the ownership interest of other Fairfax affiliates. The Company’s pro-rata share of earnings of equity method investees is recorded in the consolidated statements of income. Earnings of investment companies and similar equity method investees are reported in investment income and earnings of other equity method investees are reported as equity in earnings of investees, net of tax. Dividends received from equity method investees reduce the carrying value of the investment.
The estimated liability for unpaid losses and loss adjustment expenses (“LAE”) includes estimates of the ultimate settlement value of reported claims, incurred but not reported claims, future expenses to be incurred in the settlement of claims, and claim recoveries. These estimates are determined based on the Company’s loss experience, as well as consideration of industry experience and current trends and conditions. The estimated liability for unpaid losses and LAE is an estimate and future loss payments could differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability for unpaid losses and LAE are reflected in income in the period in which such changes are required.
The Company periodically purchases certain derivative contracts for its investment portfolio consistent with its overall investment strategy. Such derivative contracts are accounted for in accordance with SFAS No. 133, “Derivatives and Hedging”, as amended, which requires derivatives to be recorded at fair value on the balance sheet. Changes in fair value are recognized in the statement of income, unless the derivative is designated, and effective, as a cash flow hedge.
Accumulated other comprehensive income includes unrealized investment gains and losses on the Company’s available-for-sale securities and foreign currency translation gains and losses arising from the translation of financial statements of equity investees denominated in foreign currencies. As of December 31, 2004 and 2003, unrealized investment gains included in accumulated other comprehensive income were $45,479 and $38,135, respectively. As of December 31, 2004 and 2003, foreign currency translation gains were $10,396 and $5,361, respectively.
The amortized cost and fair value of fixed income securities by contractual maturity are shown below. Actual maturities may differ from maturities shown below due to the existence of call features. At December 31, 2004, securities containing call features represented 1.1% of the total fair value of the fixed income portfolio.
Certain individual available-for-sale securities had gross unrealized losses as of December 31, 2004 totaling $67,518, of which $48,060 was attributed to fixed income securities and $19,458 was attributed to equity securities. U.S. Treasury securities, the majority of which mature in 2020 or beyond, accounted for $43,712 of the gross unrealized losses in the fixed income portfolio. The total gross unrealized losses of $67,518 represented 3.5% of the cost of such securities in the aggregate.
At December 31, 2004, approximately $592, or 1.2%, of the fixed income portfolio gross unrealized losses were attributable to two securities in a loss position for greater than 12 consecutive months. One fixed income security had a gross unrealized loss totaling $1,094, which exceeded 10% of its cost at December 31, 2004. No fixed income securities had losses that were both greater than 12 consecutive months and exceeded 10% of cost.
Securities that are in a loss position are reviewed by management at least quarterly for potential impairment. Management’s review involves detailed credit analyses in the case of non-U.S. Treasury securities. While a loss position for 12 consecutive months or a 10% price decline is considered significant, upon review of securities in this category, management has concluded that such price declines are temporary market price fluctuations. Management believes the Company has sufficient liquid assets available to satisfy its operating needs and, accordingly, has the ability to hold these securities until maturity or until the anticipated recovery in market value occurs.
The components of realized investment gains for the years ended December 31, 2004, 2003 and 2002 are summarized below:
In December 2004, the Company sold corporate bonds with a face value of $62,500 to various affiliates of Fairfax. The bonds were sold at fair market value ($52,292 in the aggregate) and the Company realized a gain on these transactions of $12,114.
In June 2003, the Company invested $3.7 million in MFX, an information technology services company owned 100% by Fairfax.
The Company’s investment portfolio includes investments accounted for using the equity method. These investments consist of equity interests of between 1.2% and 33.3% with a total carrying value of $280,346 and $135,520 at December 31, 2004 and 2003, respectively, and are included in other invested assets on the consolidated balance sheets. For the years ended December 31, 2004, 2003 and 2002, earnings of equity method investees was $24,402, $13,640 and $9,939, respectively. Earnings of investment companies and similar equity method investees of $5,205, $11,229 and $9,939 in 2004, 2003 and 2002, respectively, was included in investment income on the consolidated statements of income. Pre-tax earnings of other equity method investees was $19,197 and $2,411 in 2004 and 2003, respectively, was included in equity in earnings of investees, net of tax, on the consolidated statements of income. There were no earnings from other equity method investees in 2002. Dividends received from all equity method investees were $4,173 and $1,844 in 2004 and 2003, respectively. No dividends were received from equity method investees in 2002. The Company’s aggregate share of its investees’ balance sheets is summarized as follows:
The Company’s aggregate share of its investees’ statements of income is summarized as follows:
The Company purchased its investment in Northbridge in May 2003 and holds a 15.2% interest at December 31, 2004. For the years ended December 31, 2004 and 2003, pre-tax equity in earnings of Northbridge were $18,118 and $3,180, respectively, and was included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from Northbridge were $3,591 and $1,722 in 2004 and 2003, respectively.
In July 2004, as an economic hedge against a decline in the equity markets, the Company executed short sales totaling approximately $200,000 of Standard & Poor’s Depositary Receipts (“SPDRs”). Simultaneously, the Company purchased two-year S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs to $40,000. The cost of the Options was $6,000. Both the obligations to purchase the SPDRs and the Options are carried at fair value in the consolidated financial statements. The fair value of the obligations to purchase the SPDRs is included in short-sale obligations and the fair value of the Options is included in other invested assets in the consolidated balance sheet. As of December 31, 2004, the net change in the fair values of the SPDRs and the Options totaled a loss of $15,237 and was included in realized investment gains on the consolidated statement of income. The Company also incurs investment expenses in an amount equal to the dividend earnings on the SPDRs sold. Investment expense of $2,495 was recorded for the year ended December 31, 2004. See “Regulatory and other deposits” for a discussion of collateral relating to the SPDRs.
On January 25, 2005, the Company executed an additional short sale of SPDRs in the amount of $100,000. In connection with this transaction, the Company also purchased a two-year S&P Index call option, limiting the potential loss on the future purchase of these SPDRs to $20,000.
On December 31, 2004, the Company entered into a four-month swap transaction whereby the Company receives a total equity return on a publicly traded equity security in exchange for payment of a stated rate of return tied to LIBOR. The notional value of the transaction is $42,175 and it had no fair value or gain or loss as of December 31, 2004. Future changes to the market value will be recorded as realized gains or losses.
In July 2004, in connection with the SPDRs transaction described in “Investment Gains and Losses”, the Company pledged approximately $278,000 in cash and U. S. Treasury securities as collateral for the obligation to purchase the SPDRs. These assets are recorded in assets pledged for short-sale obligations on the consolidated balance sheet. As of December 31, 2004, the fair value of the assets pledged for the purchase of the SPDRs totaled $277,899 and consisted primarily of cash and U.S. Treasury securities. Effective January 21, 2005, the Company changed the custodian of these assets to satisfy state regulatory requirements. The new custodian required that the collateral be increased to approximately $327,000.
For the year ended December 31, 2004, the Company incurred losses and LAE of approximately $96,000 (including reinsurance reinstatement premiums of approximately $13,000) associated with hurricanes Charley, Frances, Ivan and Jeanne. Such losses primarily affected the property line of business.
In 2002, the Company strengthened its asbestos reserves by $67,544 based on its latest actuarial estimates. In addition, non-latent reserves were strengthened, primarily in the commercial automobile liability and workers’ compensation lines of business for accident year 1999, partially offset by favorable development in accident years 1992 and prior for workers’ compensation, general liability and commercial multi-peril lines of business.
At December 31, 2004, the Company had reinsurance recoverable of $1,804,812, due from approximately 315 reinsurers. At such date, the five largest gross reinsurance recoverable balances aggregated $1,128,876, or 62.5% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $499,817 as of that date. The largest unsecured balance as of December 31, 2004 was $194,091 with an unaffiliated company rated A+ by A.M. Best Company.
Loss cessions to prospective corporate aggregate reinsurance in 2003 of $1,130 includes the benefit of cessions to the 2001 accident year treaty with nSpire Re Limited (“nSpire”, formerly ORC Re Limited), an affiliate of the Company, of $55,098, partially offset by charges of $53,968 associated with the commutation of two prospective corporate aggregate reinsurance contracts. The commutation charge of $53,968 included $27,193 arising from the commutation of the accident year 2001 treaty with nSpire and $26,775 related to commutation of a contract with an unrelated party covering accident years 1992 and prior.
In 1998, in connection with the acquisition of the Company by Fairfax, the Company entered into an aggregate stop loss agreement with an unaffiliated reinsurer, which provided coverage of $367,500 and has been fully utilized by the Company. The contract provided coverage for loss reserve development for August 13, 1998 and prior, the date of acquisition of the Company by Fairfax. This contract is treated as prospective reinsurance. There were no premium cessions to the contract in 2004, 2003 and 2002 and reinsurance recoverable on the contract was $367,500 at both December 31, 2004 and 2003. The Company amended the contract in 2001 to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment is treated as retroactive reinsurance and has been fully utilized by the Company. Amortization of deferred income on this amendment is included in the amortization amounts discussed previously.
On June 5, 2003, concurrent with the merger of entities under common control described in note 1 above, Crum & Forster Funding Corp., an unaffiliated special purpose entity, issued $300,000 aggregate principal amount of senior notes (the “Notes”) in a private placement, with the sole intent of having obligations under such Notes only until the Company could assume such obligations. On June 30, 2003, the Company assumed Crum & Forster Funding Corp.’s obligations under the Notes. The Notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $290,955 were used to fund an interest escrow account in the amount of approximately $63,115 to make the first four semi-annual interest payments on the Notes and to pay a dividend to Fairfax in the amount of $217,885, with the remainder used to pay related financing costs. The Notes contain certain restrictions on incurrence of additional indebtedness, dividend payments to Fairfax, asset sales and certain transactions with affiliates. In addition, the Company was required by the terms of the Notes to use its best efforts to register the Notes, or similar instruments with substantially the same terms to be exchanged for the Notes, with the Securities and Exchange Commission. Pursuant to an exchange offer, which was completed on April 20, 2004, the Company issued $300,000 aggregate principal amount of registered notes with substantially the same terms as the Notes, in exchange for all of the outstanding Notes. As required by the terms of the Notes, additional interest of $279 was incurred for the period from December 28, 2003 through April 19, 2004, after which such additional interest was no longer payable on the Notes.
The current agreements governing the bank credit facilities of Fairfax contain restrictive covenants, which prohibit Fairfax from allowing any of its subsidiaries to borrow money. These agreements are not legally binding on Crum & Forster; however, given the potential negative financial impact on Fairfax of violations of these covenants, it is expected, and should be assumed, that Fairfax, as the sole shareholder, will not permit Crum & Forster to borrow unless a modification or waiver of these covenants can be obtained.
The components of the income tax expense are summarized as follows:
Deferred income taxes reflect the income tax impact of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by income tax laws and regulations. The deferred income tax expense above does not include $6,719 and $844 in 2004 and 2003, respectively, of income taxes, which are included in equity in earnings of investees, net of tax, on the consolidated statements of income. There was no deferred income tax expense on equity in earnings of investees in 2002. Total deferred income tax (benefit) expense in 2004, 2003 and 2002 was $(17,244), $24,888 and $36,138, respectively.
At December 31, 2004, the Company had net operating and other loss carryforwards of approximately $93,362. These will expire between 2009 and 2024. Based on projections of estimated future operations, management expects the deferred income tax asset to be recovered from taxable income in future years.
A reconciliation of income taxes at the statutory federal income tax rate to the Company’s tax expense is presented below:
In the normal course of business, nSpire, a Fairfax affiliate, participates in reinsurance agreements covering substantially all reinsured lines of business. For the years ended December 31, 2004, 2003 and 2002, the Company ceded to nSpire premiums of $43,750, $29,698 and $2,454, respectively. The Company had reinsurance recoverable of $26,539 and $6,120 at December 31, 2004 and 2003, respectively, related to these reinsurance agreements.
A former parent of the Company required the transfer of a number of policies and related assets and liabilities among insurance companies controlled by the former parent, effective through assumption and indemnity reinsurance agreements. The assuming parties were required to seek novation of certain policies. As of December 31, 2004 and 2003, reinsurance recoverable from related parties included $122,222 and $126,141, respectively, from TIG, a subsidiary of Fairfax. Substantially all the recoverable balance arises from policies that had not been novated.
Effective March 1, 1999, the Company entered into a reinsurance agreement with Fairmont Specialty Insurance Company (“Fairmont”, formerly Ranger Insurance Company), a subsidiary of Fairfax, covering 100% of policies that are classified as excess liability for public entities and that incept, renew, have an anniversary date or come into effect on or after March 1, 1999. This business was produced by an agency affiliate of Fairmont. The agreement provides for the Company to receive a ceding commission of 23% of direct premiums written that are subject to the agreement. Effective June 30, 2002, this agreement was terminated and a new agreement was signed with TIG covering the same business, at substantially the same terms. The new agreement covers policies written on or after July 1, 2002. This agreement was terminated effective September 1, 2003. The Company ceded premiums of $4,878 in 2002 to Fairmont and premiums of $17,679 and $8,266 in 2003 and 2002, respectively, to TIG under these agreements. As of December 31, 2004 and 2003, the Company had reinsurance recoverable of $14,776 and $7,009, respectively, from Fairmont, and $8,922 and $4,476, respectively, from TIG, related to these agreements.
Effective February 1, 2002, the Company entered into an arrangement with TIG whereby the Company issued policies on behalf of TIG totaling $22,923 in gross premiums written. The Company entered into reinsurance agreements under which approximately 30% of the total risk under these policies was ceded to TIG with the remaining 70% ceded to third party reinsurers. This arrangement with TIG was terminated as of June 30, 2002. For the year ended December 31, 2002, the Company ceded $6,265 in premiums to TIG under this agreement. As of December 31, 2004 and 2003, the Company had reinsurance recoverable of $3,196 and $4,677, respectively, from TIG related to this agreement.
Under an agreement effective July 1, 2000, the Company appointed RiverStone Claims Management LLC (“RiverStone”), a wholly-owned subsidiary of Fairfax, as its claims manager to handle its asbestos, environmental, other latent and construction defects claims. The expense incurred for these services was $3,600 for the year ended December 31, 2004 and $2,100 per year for the years ended December 31, 2003 and 2002. The Company also engages RiverStone on a contingent basis to assist in reinsurance commutation negotiations. Fees for such services were $5, $338 and $38 in 2004, 2003 and 2002, respectively.
Fairfax purchases insurance coverage on behalf of its affiliates, including comprehensive crime, insurance companies’ professional liability, directors’ and officers’ liability and company reimbursement, employment practices liability and fiduciary liability. The Company’s share of the expense incurred for this coverage was $1,396, $1,141 and $333 per year for the years ended December 31, 2004, 2003 and 2002, respectively.
Under an agreement effective October 1, 2001 through January 1, 2004, the Company provided certain claims services to TIG. Fees billed for these services were $84 and $157 in 2003 and 2002, respectively.
Included in accounts payable and other liabilities as of December 31, 2004 and 2003 are amounts payable to Fairfax and affiliates of $4,173 and $12,216, respectively.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code, for which all employees are eligible after completing one year of service. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $3,154, $3,548 and $2,750 for the years ended December 31, 2004, 2003 and 2002, respectively.
As of December 31, 2004, the future benefit payments are expected to be as follows:
Certain employees of the Company have been granted shares of restricted common stock of Fairfax under the Fairfax Financial 1999 Restricted Share Plan. The restricted stock vests over periods ranging from five to ten years. Amortization of $1,048, $1,174 and $1,181 for the years ended December 31, 2004, 2003 and 2002, respectively, is included in the consolidated statements of income.
Rental expense, before sublease income, under these operating leases was $12,325, $18,558 and $13,697 in 2004, 2003 and 2002, respectively. Rental expense for 2003 includes a $4,312 charge for future rent payments on facilities that are currently vacant. The Company recognized $1,821, $2,064 and $1,827, in 2004, 2003 and 2002, respectively, from subleases.
Effective October 12, 2000, the Company entered into an information technology services agreement with American International Technology Enterprises, Inc. The agreement has an initial term of five years and a renewal provision that extends the initial term by additional periods of one year each. Under the agreement, the Company pays baseline charges for mainframe usage and production system support with adjustments based on actual activity. Charges under the agreement totaled $5,003, $7,426 and $12,653 in 2004, 2003 and 2002, respectively. As of December 31, 2004, future estimated minimum payments required under the agreement are $3,570 in 2005. Upon 180 days prior written notice and payment of early termination fees, the Company may terminate this agreement at any time. The mainframe usage and production system support early termination fees are $171 and $547, respectively.
The Company’s insurance subsidiaries are subject to state regulatory restrictions that limit the maximum amount of dividends they can pay to the Company. These regulations vary by state. The restrictions are generally based on the net income, investment income and policyholders’ surplus of each insurance company, and further provide that the payment of dividends must be from the earned policyholders’ surplus of the insurance company. Any payment of dividends above the regulatory limits is subject to the approval of the Insurance Commissioner in the state of domicile. The Company’s insurance subsidiaries are domiciled in the states of Delaware, New Jersey, New York and Arizona. In December 2003, US Fire and CF Indemnity changed their state of domicile from New York to Delaware.
The principal differences between statutory policyholders’ surplus and shareholder’s equity determined in accordance with GAAP relate to accounting for deferred federal income taxes, deferred policy acquisition costs, unrealized gains and losses on fixed income securities and deferred gains on retroactive reinsurance.
US Fire owns in excess of 10% of the outstanding shares of Zenith, which requires the investment to be valued as an affiliate under the Codification of Statutory Accounting Principles adopted by the NAIC in 1998. US Fire’s state of domicile has granted a permitted accounting practice to treat Zenith as a non-affiliated investment based on the absence of control by US Fire. As of December 31, 2004 and 2003, this permitted accounting practice increased statutory surplus by $11,305 and $16,050, respectively, over what it would have been had prescribed accounting practice been followed.