An important part of our strategy is to form new operating units to capitalize on various business opportunities. Since 2006, the Company formed 24 new operating units that are focused on important parts of the economy in the U.S., including healthcare, energy and agriculture, and on growing international markets, including Scandinavia, Australia, the Asia-Pacific region and South America.
In general, when a claim is reported, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment based upon known information about the claim at that time. The estimate represents an informed judgment based on general reserving practices and reflects the experience and knowledge of the claims personnel regarding the nature
The key assumptions used in calculating the most recent estimate of the loss reserves are reviewed each quarter and adjusted, to the extent necessary, to reflect historical changes, current trends and other factors observed. If the actual level of loss frequency and severity are higher or lower than expected, the ultimate losses will be different than management’s estimate. The following table reflects the impact of changes (which could be favorable or unfavorable) in frequency and severity, relative to our assumptions, on our loss estimate for claims occurring in 2013:
Approximately $1.6 billion, or 18%, of the Company’s net loss reserves as of December 31, 2013 relate to the Reinsurance-Global segment. There is a higher degree of uncertainty and greater variability regarding estimates of assumed loss reserves because those estimates are based, in part, upon information received from ceding companies. If information received from ceding companies is not timely or correct, the Company’s estimate of ultimate losses may not be accurate. Furthermore, due to delayed reporting of claim information by ceding companies, the claim settlement tail for assumed reinsurance is extended. Management considers the impact of delayed reporting in its selection of assumed loss development factors.
Following is a summary of the Company’s reserves for losses and loss expenses by business segment as of December 31, 2013 and 2012:
The Company evaluates reserves for losses and loss adjustment expenses on a quarterly basis. Changes in estimates of prior year losses are reported when such changes are made. The changes in prior year loss reserve estimates are generally the result of ongoing analysis of recent loss development trends. Original estimates are increased or decreased as additional information becomes known regarding individual claims and aggregate claim trends. Certain of the Company's insurance and reinsurance contracts are retrospectively rated, whereby the Company collects more or less premiums based on the level of loss activity. For those contracts, changes in loss and loss adjustment expenses for prior years may be fully or partially offset by additional or return premiums. Net prior year development (i.e, the sum of prior year reserve changes and prior year earned premiums changes) for each of the three years ended December 31, 2013 are as follows:
Favorable reserve development in 2011 was primarily attributable excess and surplus casualty, commercial multi-peril and reinsurance business and was concentrated in accident years 2007 through 2009.
A summary of the Company’s non-investment grade fixed maturity securities that were in an unrealized loss position at December 31, 2013 is presented in the table below.
The Company monitors the performance of its loans receivable and assesses the ability of each borrower to pay principal and interest based upon loan structure, underlying property values, cash flow and related financial and operating performance
of the property and market conditions. Loans receivable with a potential for default are further assessed using discounted cash flow analysis and comparable cost and sales methodologies, if appropriate.
The following is a summary of pricing sources for the Company's fixed maturity securities available for sale as of December 31, 2013:
fixed maturity securities. The Company reviews the syndicate manager’s pricing methodology and audited financial statements and holds discussions with the syndicate manager as necessary to confirm its understanding and agreement with security prices. Based upon the Company’s review of the methodologies used by the syndicate manager, these securities were classified as Level 2.
Premiums. Gross premiums written were $6,511 million in 2013, an increase of 13% from $5,780 million in 2012. The growth was due to a combination of rate increases and increased exposures, including expansion into new geographic and product markets. Approximately 76% of policies expiring in 2013 were renewed, compared with a 78% renewal retention rate for policies expiring in 2012.
Insurance-International gross premiums increased 12% to $899 million in 2013 from $802 million in 2012. Gross premiums increased $69 million (17%) for short-tail lines, $36 million (62%) for other liability, $2 million (3%) for workers' compensation and decreased $5 million (4%) for professional liability and $5 million (3%) for commercial auto.
Other-Than-Temporary Impairments. The cost of securities is adjusted where appropriate to include a provision for a decline in value that is considered to be other-than-temporary. Other-than-temporary impairments were $6 million in 2013 and $5 million in 2012.
Reinsurance-Global - The loss ratio of 62.2% in 2013 was 2.1 points lower than the loss ratio of 64.3% in 2012. Catastrophe losses were $16 million in 2013 compared with $23 million in 2012, a decrease of 1.4 loss ratio points. Favorable prior year reserve development was $46 million in 2013 compared with $37 million in 2012, a difference of 0.4 loss ratio points. The loss ratio excluding catastrophe losses and prior year reserve development decreased 1.1 points to 65.4% in 2013 from 66.5% in 2012.
Underwriting expenses are comprised of commissions paid to agents and brokers, premium taxes and other assessments and internal underwriting costs. Underwriting expenses increased 11% compared with an increase in net premiums earned of 12%. The expense ratio (underwriting expenses expressed as a percentage of premiums earned) was 33.9% in 2013 and 34.1% in 2012. We expect our expense ratio to further improve if insurance prices continue to increase at current levels.
Other costs and expenses represent general and administrative expenses of the parent company and other expenses not allocated to business segments, including the cost of certain long-term incentive plans. Other costs and expenses increased to $144 million in 2013 from $128 million in 2012 due primarily to an increase in compensation costs.
Income Taxes. The effective income tax rate was 28% in 2013 compared to 27% in 2012. The effective income tax rate differs from the federal income tax rate of 35% primarily because of tax-exempt investment income. Tax exempt investment income comprised a lower portion of the 2013 pre-tax income and as such had a lesser impact on the effective tax rate for 2013 compared with 2012.
The Company has not provided U.S. deferred income taxes on the undistributed earnings of approximately $103 million of its non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the non-U.S. subsidiaries. However, in the future, if such earnings were distributed to the Company, taxes of approximately $9 million, assuming all tax credits are realized, would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the foreign subsidiary.
Insurance-International gross premiums increased 18% to $802 million in 2012 from $681 million in 2011. Gross premiums increased $115 million (41%) for short-tail lines, $10 million (7%) for commercial auto, $8 million (11%) for workers' compensation and $1 million (1%) for professional liability and decreased $13 million (18%) for other liability.
Reinsurance-Global gross premiums increased 19% to $717 million in 2012 from $601 million in 2011. Gross premiums written increased $62 million (35%) for casualty business and $54 million (13%) for property lines.
Net Realized Gains on Investment Sales. The Company buys and sells securities on a regular basis in order to maximize its total return on investments. Decisions to sell securities are based on management’s view of the underlying fundamentals of specific securities as well as management’s expectations regarding interest rates, credit spreads, currency values and general economic conditions. Net realized gains on investment sales were $201 million in 2012 compared with $126 million in 2011. Investment gains in 2012 were related primarily to the sale of a private equity investment and equity securities.
Other-Than-Temporary Impairments. The cost of securities is adjusted where appropriate to include a provision for a decline in value that is considered to be other-than-temporary. Other-than-temporary impairments were $5 million in 2012 compared with $0.4 million in 2011.
For loans where the Company determines it is probable that the contractual terms will not be met, an analysis is performed and a valuation reserve is established, if necessary, with a charge to earnings. In 2012, the valuation allowance for mortgage loans decreased by $14 million.
Insurance-International - The loss ratio of 59.7% in 2012 was 2.3 points higher than the loss ratio of 57.4% in 2011. Catastrophe losses were $14 million in 2012 and in 2011, a decrease of 0.5 loss ratio points. There was no prior year reserve development in 2012 compared with favorable reserve development of $10 million in 2011, a difference of 2.0 loss ratio points. The loss ratio excluding catastrophe losses and prior year reserve development increased 0.8 points to 57.5% in 2012 from 56.7% in 2011.
Underwriting expenses are comprised of commissions paid to agents and brokers, premium taxes and other assessments and internal underwriting costs. Underwriting expenses increased 11% compared with an increase in net premiums earned of 12%. The expense ratio (underwriting expenses expressed as a percentage of premiums earned) was 34.1% in 2012 and 34.6% in 2011.
Service expenses, which represent the costs associated with the fee-based businesses, increased 13% to $85 million. The increase was due to an increase in general and administrative expenses related to fee-based business.
Net foreign currency gains of $6 million (compared with $2 million in 2011) resulted from transactions denominated in a currency other than the operating unit’s functional currency.
As part of its investment strategy, the Company establishes a level of cash and highly liquid short-term and intermediate-term securities that, combined with expected cash flow, it believes is adequate to meet its payment obligations.
The Company also attempts to maintain an appropriate relationship between the average duration of the investment portfolio and the approximate duration of its liabilities (i.e., policy claims and debt obligations). The average duration of the investment portfolio was 3.3 years and 3.4 years at December 31, 2013 and 2012, respectively. The Company’s investment portfolio and investment-related assets as of December 31, 2013 were as follows:
Investment Funds. At December 31, 2013, the carrying value of investment funds was $1,067 million, including investments in real estate funds of $378 million, hedged equity funds of $272 million and investments in energy funds of $155 million. Investment funds are reported on a one-quarter lag.
Real Estate. Real estate is directly owned property held for investment. At December 31, 2013, real estate consists of one office building in operation, two office buildings and a mixed-use project under development and a long-term ground lease.
As a holding company, the Company derives cash from its subsidiaries in the form of dividends, tax payments and management fees. Maximum amounts of dividends that our insurance companies can pay without regulatory approval are prescribed by statute. During 2014, the maximum amount of dividends which can be paid without regulatory approval is approximately $491 million. The ability of the holding company to service its debt obligations is limited by the ability of its insurance subsidiaries to pay dividends. In the event dividends, tax payments and management fees available to the holding company were inadequate to service its debt obligations, the Company would need to raise capital, sell assets or restructure its debt obligations.
The Company files a consolidated income tax return in the U.S. and foreign tax returns in each of the countries in which it has overseas operations. At December 31, 2013, the Company had a deferred gross tax asset of $431 million (which primarily relates to loss and loss expense reserves and unearned premium reserves) and a gross deferred tax liability of $411 million (which primarily relates to deferred policy acquisition costs and unrealized investment gains). The realization of the deferred tax asset is dependent upon the Company's ability to generate sufficient taxable income in future periods. Based on historical results and the prospects for future operations, management anticipates that it is more likely than not that future taxable income will be sufficient for the realization of this asset.
Casualty reinsurance treaties - The Company purchases casualty reinsurance to reduce its exposure to large individual casualty losses, workers’ compensation catastrophe losses and casualty losses involving multiple claimants or insureds. A significant casualty treaty in effect as of January 1, 2014 provides protection for losses from single events with claims from two or more claimants or insureds. This treaty provides protection for losses between $2.5 million and $65 million for casualty business. For primary workers’ compensation business, coverage is generally in place for losses between $5 million and $125 million. For excess workers’ compensation business, coverage is generally in place for losses between $25 million and $195 million.
The Company places most of its significant casualty treaties on a “risk attaching” basis. Under risk attaching treaties, all claims from policies incepting during the period of the reinsurance contract are covered even if they occur after the expiration date of the reinsurance contract. If the Company is unable to renew or replace its existing reinsurance coverage, protection for unexpired policies would remain in place until their expiration. In such case, the Company could revise its underwriting strategy for new business to reflect the absence of reinsurance protection. Property catastrophe and workers’ compensation catastrophe reinsurance is generally placed on a “losses occurring basis,” whereby only claims occurring during the period are covered. If the Company is unable to renew or replace this reinsurance coverage, unexpired policies would not be protected.
Following is a summary of earned premiums and loss and loss expenses ceded to reinsurers for each of the three years ended December 31, 2013:
Ceded earned premiums increased 17% in 2013 to $960 million. The increase was higher than the increase in direct and assumed earned premiums of 13% due primarily to growth in assigned risk plan business, which is fully reinsured, and to an increase in ceded premiums for professional liability business. The ceded losses and loss expenses ratio decreased 6.3 points to 58.0% in 2013 from 64.3% in 2012. Ceded loss and loss adjustment expenses in 2012 included $134 million of reinsurance loss recoveries related to Superstorm Sandy.
from reinsurers are net of reserves for uncollectible reinsurance of $1 million in the aggregate.
(2) Secured by letters of credit or other forms of collateral.
The Company utilizes letters of credit to back certain reinsurance payments and obligations. Outstanding letters of credit were $13 million as of December 31, 2013. The Company has made certain guarantees to state regulators that the statutory capital of certain subsidiaries will be maintained above certain minimum levels.
Property, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the estimated useful lives of the respective assets. Depreciation expense was $38 million, $38 million and $40 million for 2013, 2012 and 2011, respectively.
Goodwill and other intangible assets are tested for impairment on an annual basis and at interim periods where circumstances require. The Company's impairment test as of December 31, 2013 indicated that there were no impairment losses related to goodwill and other intangible assets. Intangible assets of $72 million and $31 million are included in other assets as of December 31, 2013 and 2012, respectively.
Interest payments were $125 million, $119 million and $111 million in 2013, 2012 and 2011, respectively. Income taxes paid were $186 million, $133 million and $48 million in 2013, 2012 and 2011, respectively. Other non-cash items include acquisitions, unrealized investment gains and losses and pension expense. (See Note 2, Note 11 and Note 26 of Notes to Consolidated Financial Statements.)
In October 2010, the Financial Accounting Standards Board ("FASB") issued guidance regarding the treatment of costs associated with acquiring or renewing insurance contracts. This guidance modified the definition of the types of costs that can be capitalized and specifies that the costs must be directly related to the successful acquisition of a new or renewed insurance contract. The Company adopted this guidance effective January 1, 2012 and retrospectively adjusted its previously issued financial statements. The impact of applying this guidance retrospectively was a reduction in stockholders' equity of $49 million as of January 1, 2010.
Information has been restated as a result of the adoption of this new guidance throughout these consolidated financial statements and notes, where applicable.
In 2012, the Company acquired a 49% interest in a worldwide supplier of after-market original equipment manufacturer (OEM) parts, systems and custom logistic support services for military aircraft operations for $43 million. In January 2013, the Company acquired the remaining 51% of this business for $43 million. The estimated useful lives of the intangible assets acquired range from 2 years to 15 years, with approximately $3 million having an indefinite life.
Gross unrealized losses for mortgage-backed securities include $1,961,247 and $3,037,000, as of December 31, 2013 and 2012, respectively, related to the non-credit portion of OTTI recognized in other comprehensive income.
The amortized cost and fair value of fixed maturity securities at December 31, 2013, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers may have the right to call or prepay obligations.
At December 31, 2013 and 2012, the fair value and carrying value of the arbitrage trading account were $522 million and $329 million, respectively. The primary focus of the trading account is merger arbitrage. Merger arbitrage is the business of investing in the securities of publicly held companies which are the targets in announced tender offers and mergers. Arbitrage investing differs from other types of investing in its focus on transactions and events believed likely to bring about a change in value over a relatively short time period (usually four months or less). The Company believes that this makes arbitrage investments less vulnerable to changes in general financial market conditions.
The Company uses put options, call options and swap contracts in order to mitigate the impact of potential changes in market conditions on the merger arbitrage trading account. These options and contracts are reported at fair value. As of December 31, 2013, the fair value of long option contracts outstanding was $2 million (notional amount of $28 million) and the fair value of short option contracts outstanding was $2 million (notional amount of $22 million). Other than with respect to the use of these trading account securities, the Company does not make use of derivatives.
Properties in operation represent an office building in London and a long-term ground lease in Washington D.C. These properties are net of accumulated depreciation and amortization of $17,827,000 and $10,354,000, as of December 31, 2013 and 2012, respectively. Related depreciation expense was $7,474,000, $7,583,000 and $2,770,000 for the years ended December 31, 2013, 2012 and 2011, respectively. Future minimum rental income expected on operating leases relating to real estate held for investment is $1,504,000 in 2014, $1,549,000 in 2015, $1,596,000 in 2016, $1,644,000 in 2017, $1,693,000 in 2018 and $327,320,000 thereafter.
There were no loans receivable in non-accrual status December 31, 2013, compared to $3 million at December 31, 2012. If these loans had been current at December 31, 2012, additional interest income of $498,000 would have been recognized in accordance with their original terms for the year ended December 31, 2012.
The following table summarizes all securities in an unrealized loss position at December 31, 2013 and 2012 by the length of time those securities have been continuously in an unrealized loss position.
Because many fixed maturity securities do not trade on a daily basis, the Company utilizes pricing models and processes which may include benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Market inputs used to evaluate securities include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. Quoted prices are often unavailable for recently issued securities, securities that are infrequently traded or securities that are only traded in private transactions. For publicly traded securities for which quoted prices are unavailable, the Company determines fair value based on independent broker quotations and other observable market data. For securities traded only in private negotiations, the Company determines fair value based primarily on the cost of such securities, which is adjusted to reflect prices of recent placements of securities of the same issuer, financial projections, credit quality and business developments of the issuer and other relevant information.
The following tables present the assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 and 2012 by level:
There were no significant transfers in or out of Level 3 during the years ended December 31, 2013 or 2012.
For the year ended December 31, 2013, estimates for claims occurring in prior years (net of additional and return premiums) decreased by $98 million. The favorable reserve development in 2013 was primarily attributable to accident years 2008 through 2010. The changes in prior year loss reserve estimates are generally the result of ongoing analysis of recent loss development trends. Original estimates are increased or decreased as additional information becomes known regarding individual claims and aggregate claim trends.
to discounting was derived from the Company’s loss payout experience. For non-proportional business, reserves for losses and loss expenses have been discounted using risk-free discount rates determined by reference to the U.S. Treasury yield curve. At December 31, 2013, the discount rates by year ranged from 2.1% to 6.5% with a weighted average discount rate of 4.1%. For proportional business, reserves for losses and loss expenses have been discounted at the statutory rate permitted by the Department of Insurance of the State of Delaware of 2.2%. The aggregate net discount, after reflecting the effects of ceded reinsurance, was $837 million, $867 million and $892 million at December 31, 2013, 2012 and 2011, respectively.
In 2013, the Company issued $350,000,000 aggregate principal amount of 5.625% Subordinated Debentures due April 2053 (the “Debentures”). At December 31, 2013, the carrying value of the Debentures, net of unamortized discount, was $339,800,000. The net proceeds of the offering was primarily used to repay the $250 million aggregate principal amount of the Company's 6.750% Subordinated Debentures due 2045. The Company realized a loss from the early redemption of $7 million.
The Company’s insurance subsidiaries are restricted by law as to the amount of dividends they may pay without the approval of regulatory authorities. The Company’s lead insurer, Berkley Insurance Company (BIC), directly or indirectly owns all of the Company’s other insurance companies. During 2014, the maximum amount of dividends that can be paid by BIC without such approval is approximately $491 million.
The National Association of Insurance Commissioners (“NAIC”) has risk-based capital (“RBC”) requirements that require insurance companies to calculate and report information under a risk-based formula which measures statutory capital and surplus needs based on a regulatory definition of risk in a company’s mix of products and its balance sheet. This guidance is used to calculate two capital measurements: Total Adjusted Capital and RBC Authorized Control Level. Total Adjusted Capital is equal to the Company’s statutory capital and surplus excluding capital and surplus derived from the use of permitted practices that differ from statutory accounting practices. RBC Authorized Control Level is the capital level used by regulatory authorities to determine whether remedial action is required. Generally, no remedial action is required if Total Adjusted Capital is 200% or more of the RBC Authorized Control Level. At December 31, 2013, BIC’s Total Adjusted Capital of 4.6 billion was 4.53% of its RBC Authorized Control Level.
The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as of December 31, 2013 and 2012:
The Company and its subsidiaries use office space and equipment under leases expiring at various dates. These leases are considered operating leases for financial reporting purposes. Some of these leases have options to extend the length of the leases and contain clauses for cost of living, operating expense and real estate tax adjustments. The Company also has an investment in a commercial office building that has a long-term land lease. Future minimum lease payments, without provision for sublease income, are: $42,586,000 in 2014; $39,218,000 in 2015; $34,009,000 in 2016; $29,573,000 in 2017 and $213,046,000 thereafter. Rental expense was $44,752,000, $38,179,000 and $33,003,000 for 2013, 2012 and 2011, respectively.
Upon vesting, shares of the Company’s common stock equal to the number of vested RSUs are issued or deferred to a later date, depending on the terms of the specific award agreement. As of December 31, 2013, 3,643,804 shares related to vested RSUs had been deferred.
The Company and its subsidiaries have profit sharing plans in which substantially all employees participate. The plans provide for minimum annual contributions of 5% of eligible compensation; contributions above the minimum are discretionary and vary with each participating subsidiary’s profitability. Employees become eligible to participate in the profit sharing plans on the first day of the month following the first full three months in which they are employed. The plans provide that 40% of the contributions vest immediately and that the remaining 60% vest at varying percentages based upon years of service. The Company’s foreign subsidiaries provide pension benefits in accordance with local regulations. Profit sharing expense was $34 million, $31 million, and $27 million in 2013, 2012 and 2011, respectively.
The following table summarizes the LTIP expense for the three years ended December 31, 2013:
The net after tax periodic pension cost of $7 million will be amortized from accumulated other comprehensive income into periodic benefit cost during 2014.
Insurance-International - insurance business primarily in the United Kingdom, Continental Europe, South America, Canada, Scandinavia, and Australia; and
All domestic insurance operating companies, previously included in the Specialty, Regional and Alternative Markets segments, were aggregated into the Insurance-Domestic segment; all reinsurance operating companies were aggregated into the Reinsurance-Global segment; and all international insurance companies were aggregated into the Insurance-International segment. The segment disclosures for prior periods have been revised to be consistent with the new reportable business segment presentation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Income tax expense and benefits are calculated based upon the Company’s overall effective tax rate.
Summary financial information about the Company’s operating segments is presented in the following table. Income (loss) before income taxes by segment includes allocated investment income. Identifiable assets by segment are those assets used in or allocated to the operation of each segment.