The Company leases office space in San Antonio, Texas for its corporate headquarters as well as for certain support functions for Argonaut Insurance Company. Argonaut Insurance Company's headquarters are located in a facility that consists of an office building on approximately two acres of land in Menlo Park, California. Argonaut Great Central's headquarters are located in a facility in Peoria, Illinois. Argonaut Insurance Company and Argonaut Great Central own the buildings in which their headquarters are located. In addition, the Company has entered into other leases in conjunction with its operations at various locations throughout the country. The Company believes that its properties are adequate for its present needs.
The following selected financial data are derived from the Company's consolidated financial statements. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Results of Operation and Financial Condition", included under
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 38. This discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.
Consolidated net investment income reflects the impact of lower investment yields on higher invested assets due to positive cash flows from operations for the year ended December 31, 2002. Total invested assets were approximately $1,181.3 million, $1,153.2 million and $1,085.5 million as of December 31, 2002, 2001 and 2000, respectively.
The consolidated loss ratios were 88.4%, 85.5% and 198.7% for the years ended December 31, 2002, 2001 and 2000, respectively. Losses and loss adjustment expenses were increased by approximately $59.8 million (or 15.8% of earned premiums for the year) during 2002 due to reserve strengthening in the run-off lines, particularly relating to the Company's asbestos liabilities. (See the section entitled "Run-off Lines" on pages 24 - 28 for further discussion.) The loss ratio for the year ended December 31, 2000, includes reserve strengthening of approximately $134.0 million relating to the specialty workers' compensation segment (see discussion on page 23.)
Segment Identification. As a result of acquisition of Front Royal, a new business segment reporting structure was implemented in the fourth quarter of 2001. The ongoing business segments are: excess and surplus lines, specialty commercial, specialty workers' compensation and public entity. All prior periods presented have been reclassified to reflect the current segments.
In evaluating the operating performance of its segments, the Company focuses on core underwriting and investing results before consideration of realized gains or losses from the sales of investments. Although this measure of profit (loss) does not replace net income (loss) computed in accordance with GAAP as a measure of profitability, management utilizes this measure of profit (loss) to focus its segments on generating operating income which excludes realized gains and losses on sales of investments.
Excess and Surplus Lines. Colony provides commercial property and casualty insurance on both an admitted and non-admitted basis, focusing primarily on excess and surplus lines, providing a market for insurance covering risks for which there is not a ready market from admitted carriers. Colony's insureds include restaurants, artisan contractors, day-care centers, manufacturers and other professionals. Colony was acquired by the Company effective September 1, 2001, and its results from operations are included from this date. The Company did not have a comparable segment prior to that date.
Gross written premiums for the year ended 2002 included approximately $132.3 million related to new business. During 2002, this segment underwrote new business through its renewal rights acquisition of Fulcrum Insurance Company, resulting in additional gross written premiums of approximately $53.9 million. Renewal premiums for the year ended December 31, 2002 were approximately $83.0 million. The retention rate was approximately 37.2% of policies written in the prior year and 55.5% of written premium for the year ended December 31, 2002. This is a reflection of the current environment of the excess and surplus lines market, in that the current year premium has a similar risk profile to expiring business, and is being written at higher rates. Partially offsetting these increases were cancellations and endorsements which reduced gross written premiums by approximately $11.3 million. Results for the year ended December 31, 2001 include activity for the four months since acquisition of Colony.
The excess and surplus lines segment's loss ratio was 63.4% for the year ended December 31, 2002 compared to 60.6% for the four month period ended December, 31, 2001. The increase in the loss ratio during 2002 was attributable to two factors. First, although similar in risk profile, the business generated by the new markets is recorded at a higher loss ratio to recognize the uncertainty associated with this new business. Second, improvements in claims handling procedures implemented during 2002 resulted in a strengthening of case reserves. These improvements in claims handling procedures have resulted in better control over future loss development and ultimate loss settlements. Loss reserves for the excess and surplus lines were $180.1 million and $138.7 million as of December 31, 2002 and 2001, respectively.
The expense ratio for the year ended December 31, 2002 was 31.3%, compared to 33.4% for the four months ended December 31, 2001. Colony continues to manage its underwriting expenses and has realized a benefit in a reduction in the expense ratio due to increased premium volume.
Specialty Commercial. Argonaut Great Central and Rockwood provide specialty commercial insurance coverage. Argonaut Great Central specializes in commercial multi-peril, workers' compensation and umbrella insurance coverage in three broadly defined markets: food and hospitality, retail services and organizations and institutions. Rockwood provides commercial property and casualty insurance primarily in Pennsylvania and Maryland. Rockwood focuses on underwriting workers' compensation coverage, general liability and other property and casualty coverage for commercial and mining risks.
For the year ended December 31, 2002, the specialty commercial segment reported segment profit of $10.5 million and a combined ratio of 99.7%, compared to segment profit of $5.0 million and a combined ratio of 103.0% for the same period ended 2001. For the year ended December 31, 2000, this segment reported a segment loss of $6.6 million and a combined ratio of $140.9%.
The expense ratio for the specialty commercial segment was 28.8% for the year ended December 31, 2002, compared to 29.2% and 46.1% for 2001 and 2000, respectively. The continued improvement in the expense ratio was primarily the result of increased premium volumes and cost containment.
Specialty Workers' Compensation. Specialty workers' compensation is the primary line of insurance written by Argonaut Insurance Company. Argonaut Insurance Company generally targets companies whose workers' compensation needs will result in significant annual premiums (generally between $250,000 and $5 million). These classes of insurance require specific underwriting expertise and a commitment to enhance the safety of the workplace. Insureds partner with Argonaut Insurance Company to effectively manage losses.
Gross written premiums for the year ended December 31, 2002 include approximately $82.9 million in premiums on new policies, an increase of approximately $37.6 million over 2001. The increase was primarily attributable to business acquired through a renewal rights purchase and small workers' compensation products. Renewal premiums for the year ended December 31, 2002 totaled $94.8 million, an increase of $8.3 million over 2001. The specialty workers' compensation segment's retention ratio was 60%, with an average premium rate increase of 15%. Gross written premiums were comparable for the years ended December 31, 2001 and 2000.
As of December 31, 2002, 2001 and 2000, the following is certain claims data with respect to specialty workers' compensation:
Decreases in net investment income were the result of declining invested assets coupled with declining yields. Total invested assets, as respect to specialty workers' compensation, declined from $990.2 million at December 31, 2000 to $690.5 million and $629.0 million at December 31, 2001 and 2002, respectively. The decline in the invested balances between 2000 and 2001 was primarily related to the disbursement of funds related to the acquisition of Front Royal.
Public Entity. Trident functions as a managing general underwriter, dedicated to servicing the insurance needs of governmental entities throughout the United States. Trident, through Argonaut Great Central and, to a lesser extent, Argonaut Insurance Company, provides property and casualty insurance to municipalities with populations of less than 30,000, counties with populations of less than 100,000 and special purpose districts such as water districts. Trident commenced activity in 2000, and results for the year ended December 31, 2000 were not material.
The increase in gross written premiums was primarily the result of new business written in 2002. For the year ended December 31, 2002, the public entity segment's new business was approximately $21.9 million. Additionally, the segment wrote $11.9 million of renewal business, of which $1.6 million represented rate increases. The public entity segment's retention ratio was 64.9% during 2002.
The expense ratio for the year ended December 31, 2002 was 32.0% compared to 28.2% for 2001. The increase in the expense ratio primarily resulted from a reduced ceding commission on the segment's quota share reinsurance agreement.
Argonaut Insurance Company is exposed to asbestos liability at the primary level through claims filed against its direct insureds, as well as through its position as a reinsurer of other primary carriers. Argonaut Insurance Company's direct liability arises primarily from policies issued from the mid 1970s to early 1980s which pre-dated policy contract wording that excluded asbestos exposure. The majority of the policies were issued on behalf of small contractors or construction companies. The Company believes that the frequency and severity of asbestos claims for such insureds is typically less than that experienced for large, industrial manufacturing and distribution concerns.
Argonaut Insurance Company also assumed risk as a reinsurer for a limited period of time, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance Company reinsured risks on policies written by direct carriers. The reinsurance typically provided coverage for limits attaching at a relatively high dollar amount which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance Company are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no current medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that claims generated out of this population of claimants will likely be characterized by high frequency but low severity, resulting in incurred losses generally lower than the asbestos claims filed over the past decade and could be below Argonaut Insurance Company's attachment level.
The following table represents a reconciliation of total gross and net reserves for the run-off lines for each of the years in the three-year period ended December 31, 2002. Amounts in the net column are reduced by reinsurance recoverables.
Reserves for the run-off lines, especially environmental and asbestos liabilities, are reviewed and updated. Argonaut Insurance Company conducted a study of its asbestos and environmental reserves in the fourth quarter of 2002, and as a result strengthened its asbestos reserves by $52.8 million.
However, some uncertainty remains regarding the severity and frequency of future claims to the extent that other carriers and policyholders may not have provided notice of loss or addressed issues of coverage. Additional uncertainty is created by continued unfavorable trends in the insurance industry related to asbestos. All of these factors were considered as part of the decision to strengthen reserves in the fourth quarter of 2002. Although legislative reform for class action lawsuits, judicial and legislative actions imposing minimum proof requirements, and other tort-related reforms are possible in the near term, the study did not take these mitigating factors into account in evaluating the severity or frequency of claims.
Total reserves for environmental and asbestos claims were $178.3 million, net of reinsurance. Management uses various actuarial methods to determine the potential range of losses for the run-off lines in total, which resulted in a range of potential ultimate liability, net of reinsurance, of $146.7 million to $329.7 million. In determining their best estimate, management primarily relied on the report year method. The report year method relies the most heavily on the Company's historical claims and severity information, whereas other methods rely more heavily on industry information. As a result of this reserve increase, the reserve for incurred but not reported environmental and asbestos claims (net of reinsurance) at December 31, 2002, was $102.1 million for total environmental and asbestos reserves, compared to $58.2 million as of December 31, 2001. The reserve for incurred but not reported claims for the remaining run-off lines (net of reinsurance) was $15.3 million as of December 31, 2002, compared to $18.8 million as of December 31, 2001.
The following table represents a reconciliation of environmental and asbestos claims outstanding for each of the years in the three-year period ended December 31, 2002.
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2002.
The Company, through its subsidiary Argonaut Insurance Company, has been named in various legal actions filed by MacArthur Company, Western Asbestos Company and certain other individual claimants. Argonaut Insurance Company's involvement in these actions stems from nine construction wrap-up policies with an occurrence limit of $200,000 per policy issued to Western MacArthur Company and Western Asbestos Company, respectively, for liability arising out of work performed on five construction sites in the 1960's and 1970's. Management estimates that approximately 1% of the claimants in the purported class action suits against Western MacArthur were associated in any way with the job sites covered by the Argonaut Insurance Company policies. Argonaut Insurance Company has in the ordinary course of business set up reserves in connection with these claims in prior years. Based on this limited exposure, management believes current reserves are sufficient to cover any losses which may arise out of these actions.
The Company's insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to cover operating expenses. During the three years ended December 31, 2002, the Company's liquidity generated from operations and investment income were sufficient to meet obligations. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
As of December 31, 2002, the Company had repurchased and retired approximately 7.9 million shares of its common stock out of a total 10 million shares authorized for repurchase. No common stock was repurchased and retired during 2002.
On March 31, 2003, the Company sold approximately 2.4 million shares of Series A Mandatory Convertible Preferred Stock. The preferred shares were sold through a private placement to a group of investors. The Company received gross proceeds of $29.4 million from HCC Insurance Holdings, Inc. as a result of this sale. The proceeds were used to increase the statutory surplus and RBC of Argonaut Insurance Company. The preferred shares are convertible at any time into common stock at the option of the holder at an initial conversion price of $12.00. Any outstanding preferred shares will automatically convert into common shares on the tenth anniversary of the issuance. The preferred shares will initially pay a 7 percent dividend on a quarterly basis. The dividend rate is subject to certain adjustments based upon the Company's A.M. Best rating and Risk Based Capital level. The holders of the preferred shares will be entitled to vote on an as-converted basis on all matters submitted for the vote of the Argonaut Group common shareholders. Additionally, under the terms of the private placement, the Company has agreed not to pay dividends to common shareholders for a period of two years.
On March 31, 2003 the Company borrowed $18.0 million from HCC Insurance Holdings, Inc. The Company contributed $12.0 million of the borrowing to Argonaut Insurance Company, $5.0 million will be held in escrow for dividend payments related to the Series A Mandatory Convertible Preferred Stock, and $1.0 million will be held by the Company for general corporate purposes. The note payable is due March 31, 2006, bears interest at 12% annually and is prepayable at the Company's option at anytime. The note contains certain covenants, one of which requires repayment should the Company enter into other debt agreements or issues additional shares of Series A Mandatory Convertible Preferred Stock.
Additionally, the Company has an agreement with an additional investor to participate in the issue of the Series A Mandatory Convertible Preferred Stock. The investor has committed to a $6.0 million investment. The proceeds from this investor are expected to be received on April 10, 2003. The proceeds from this sale will be used to prepay a portion of the debt discussed above.
The insurance subsidiaries must maintain certain levels of policyholders' surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners suggest that a property and casualty insurer's ratio of annual statutory net premium written to policyholders' surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the insurance subsidiaries to their combined policyholders' surplus was 2.3-to-1 as of December 31, 2002. Current levels of policyholders' surplus are adequate to support current premium writings, based on this standard. The Company is currently monitoring premium and statutory surplus levels of the insurance subsidiaries to ensure that the subsidiaries maintain adequate premiums to surplus ratio. Failure of any insurance subsidiary to maintain adequate levels of policyholders' surplus could negatively impact the ability to write additional premiums.
o An analysis of the conditions that contributed to the company's financial condition; o Proposals to improve Argonaut Insurance Company's RBC; o Projections of the company's financial results, such as operating income, net income, capital and surplus, with and without proposed corrective actions; o Key assumptions underlying the projections and their related sensitivity; and o Quality of and problems with the company's business.
The following factors contributed to deterioration of the Company's RBC ratio during the year ended December 31, 2002:
o Reducing its exposure to the equity markets; o Selling certain real estate holdings that will result in realized gains and therefore increase surplus; o Scaling back operations of the less profitable business segments; and o Pursuing capital raising avenues.
The Company is in the process of documenting its plan to the California Department of Insurance detailing the actions Argonaut Insurance Company will implement to restore the RBC ratio to above minimum requirements.
On March 31, 2003, AGI Properties, Inc., sold certain parcels of real estate for $40.0 million. AGI Properties, Inc. received $8.0 million in cash and issued notes receivable for the remaining $32.0 million. The notes receivable pay interest at LIBOR plus 400 basis points, are capped at 6% and are payable September 30, 2004. The result of the sales of certain real estate and the related realized gains increased Argonaut Insurance Company's statutory surplus by approximately $32.0 million and correspondingly increased Argonaut Insurance Company's RBC.
On March 31, 2003 the Company borrowed $18.0 million from HCC Insurance Holdings, Inc. and contributed the full amount of the borrowing to Argonaut Insurance Company. The note payable is due March 31, 2006, bears interest at 12% annually and is prepayable at the Company's option at anytime. The note contains certain covenants, one of which requires repayment should the Company enter into other debt agreements or issues additional shares of Series A Mandatory Convertible Preferred Stock.
The determination of pension plan expense and the requirements for funding the Company's pension plans are based on a number of actuarial assumptions. Management's selection of plan assumptions, primarily the discount rate used to calculate the projected benefit obligation and the expected long-term rate of return on plan assets, can have a significant impact on the resulting estimated projected benefit obligation and pension cost, and thus on the consolidated results of operations. Such plan assumptions are determined annually, subject to revision if significant events occur during the year.
The pension plan measurement date for purposes of our consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which management believes the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2002, the Company modified certain assumptions surrounding the Company's pension plans. Specifically, the Company reduced its assumptions on discount rate from 7.5% to 6.75% and expected rate of increase in future compensation levels from 4.5% to 4.0%. The expected rate of return on plan assets remained unchanged at 6.0%.
The Company utilized Fayez Sarofim & Co. to manage a portion of its investment portfolio, for which an investment advisory fee is paid. Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez Sarofim, a member of the Company's board of directors, is the majority shareholder. Total fees for services paid to Fayez Sarofim & Co. were approximately $0.5 million, $0.6 million and $0.7 million for the years ended December 31, 2002, 2001 and 2000, respectively. The Company believes that this transaction has been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
The Company utilizes a variety of actuarial techniques and methods to determine the ultimate losses and loss adjustment expenses. Methods used include paid loss development method, incurred loss development method, Bornhuetter-Ferguson method, loss ratio method, report year method and claim count development method. The combination of the methods produces a point estimate for each line of business, which the Company books as management's best estimates given the available facts at that point in time. Each business segment is analyzed individually. The Company uses internal data in the analysis, however, industry data is used where credibility of internal data is low and in the development of tail factors. The Company analyzes loss reserves on a monthly basis. An independent actuary reviews the specialty workers' compensation reserves on a quarterly basis. A study of reserves by the Company's consulting actuary for the run-off lines is conducted semi annually using additional actuarial methods.
In addition to the previously described general uncertainties encountered in estimating reserves, there are significant additional uncertainties in estimating the amount of the Company's potential losses from asbestos and environmental claims. Reserves for asbestos and environmental claims cannot be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding these types of claims. Among the uncertainties impacting the estimation of such losses are: (1) potentially long waiting periods between exposure and emergence of any bodily injury or property damage; (2) difficulty in identifying sources of environmental or asbestos contamination; (3) difficulty in properly allocating responsibility and/or liability for environmental or asbestos damage; (4) changes in underlying laws and judicial interpretation of those laws; (5) potential for an environmental or asbestos claim to involve many insurance providers over many policy periods; (6) long reporting delays from insureds to insurance companies (7) historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of claims; (8) questions concerning interpretation and application of insurance coverage; and (9) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure. Case reserves and expense reserves for costs of related litigation have been established where sufficient information has been developed. Additionally, incurred but not reported reserves have been established to cover additional exposure on known and unknown claims.
The Company currently underwrites environmental and pollution coverages on a limited number of policies and underground storage tanks. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding company not dissimilar to those results the industry has experienced with regard to asbestos and environmental related claims. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and could have a material adverse effect on the Company's future financial condition, results of operations and cash flows.
Through its subsidiary, Rockwood, the Company has exposure to claims for black lung disease. Those diagnosed with black lung disease are eligible to receive workers' compensation benefits from various federal and state programs. These programs are continually being reviewed by the governing bodies and may be revised without notice in such a way as to increase the level of the Company's exposure. Reserves for losses are maintained for these exposures and, in management's opinion, adequately cover the Company's risk.
Management believes that the aggregate loss reserves at December 31, 2002 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. In establishing these reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts and the legislatures in the recent past and the 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 the ratings assigned to the insurance subsidiaries by the nationally recognized insurance rating agencies.
The Company evaluates its investment portfolio for impairments to individual securities which are deemed to be other than temporary. The Company evaluates each individual security based on a variety of factors, such as trends in the market price, degree to which market price is below cost, length of time security has been trading below cost, changes in dividend and interest payment pattern and ability of the Company to hold the security to allow for recovery. For those securities where the Company's acquisition cost is greater than fair market value, the Company discusses such securities internally or with its investment advisor. If the Company determines a decline in value is other than a temporary situation, the cost basis of the security is written down to its fair value with the amount of the write down included in earnings as a realized loss in the period the impairment was identified. During the year ended December 31, 2002, realized investment gains for the equity and bond portfolios were reduced $4.0 million and $0.9 million, respectively, due to the recognition of other than temporary impairment on certain securities (pre-tax.) During the years ended December 31, 2001 and 2000, no securities were identified as having incurred an impairment that was determined to be other than temporary.
The Company regularly monitors its investment portfolio for securities which have suffered an impairment which is deemed to be other than temporary. Of those securities whose acquisition cost exceeded fair market value at December 31, 2002, approximately $14.3 million (pre-tax) are at risk of being written down in the next twelve months.
Deferred Acquisition Costs. Policy acquisition costs, which include commissions, premium taxes, fees and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The Company continually reviews the methods of making such estimates and establishing the deferred costs, and any adjustments are made in the accounting period in which the adjustment arose.
Deferred Tax Asset. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are recognized for temporary differences that will result in taxable amounts in future years. Deferred tax assets are recognized for deductible temporary differences and tax operating loss and tax credit carryforwards. The deferred tax assets and liabilities are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The components of the Company's deferred tax asset are net operating loss carryforwards and temporary differences primarily attributable to loss reserve discounting. The net operating loss carryforwards begin expiring after 2009. The Company's deferred tax liabilities resulted from unrealized gains in the investment portfolio.
The report of the independent auditors, the consolidated financial statements of Argonaut Group, Inc. and subsidiaries and the supplementary financial information called for by this Item 8 are included in this report beginning on page and are incorporated herein by reference.