(1) On April 15, 2016, we acquired Jazwares; on October 31, 2015, we acquired IPS; on August 30, 2013, we acquired Kentucky Trailer; on April 26, 2012, we acquired Bourn & Koch; and on March 6, 2012, we acquired TransRe.
Underwriting profit is a non-GAAP financial measure for our reinsurance and insurance segments. Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include: (i) net investment income; (ii) net realized capital gains; (iii) other than temporary impairment, or “OTTI” losses; (iv) other revenue; (v) other operating expenses; (vi) corporate administration; (vii) amortization of intangible assets; and (viii) interest expense. We consistently use underwriting profit as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of our segments and believe that underwriting profit provides useful additional information to investors because it highlights net earnings attributable to a segment’s underwriting performance. Earnings before income taxes may show a profit despite an underlying underwriting loss, and when underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. A reconciliation of underwriting profit to earnings before income taxes is presented within “Consolidated Results of Operations.”
Earnings before income taxes were $647.8 million in 2016, compared with $757.4 million in 2015 and $931.9 million in 2014.
Net premiums written increased by 13.4 percent in 2016 from 2015, and decreased by 0.2 percent in 2015 from 2014.
Underwriting profit was $401.3 million in 2016, compared with $466.6 million in 2015 and $494.8 million in 2014.
The combined ratio for our reinsurance and insurance segments was 91.9 percent in 2016, compared with 89.0 percent in 2015 and 88.8 percent in 2014.
Catastrophe losses, net of reinsurance, were $226.0 million in 2016, compared with $62.0 million in 2015 and $95.2 million in 2014.
Sales revenues for Alleghany Capital were $687.1 million in 2016, compared with $241.0 million in 2015 and $145.6 million in 2014.
Losses before income taxes for Alleghany Capital were $105.7 million in 2016, compared with $43.1 million in 2015 and $14.6 million in 2014. Adjusted EBITDA was $25.1 million in 2016, compared with $0.4 million in 2015 and ($8.5) million in 2014.
As of December 31, 2016, we had total assets of $23.8 billion and total stockholders’ equity attributable to Alleghany stockholders of $7.9 billion. As of December 31, 2016, we had consolidated total investments of approximately $18.1 billion, of which $13.0 billion was invested in debt securities, $3.1 billion was invested in equity securities, $0.8 billion was invested in short-term investments, $0.6 billion was invested in commercial mortgage loans and $0.6 billion was invested in other invested assets.
Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, we classify our businesses into two reportable segments - reinsurance and insurance. Other activities include Alleghany Capital and corporate activities. See Note 13 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on our segments and other activities. The results for our segments and for other activities for the 2016, 2015 and 2014 are shown in the tables below:
2016 vs 2015. The increase in gross and net premiums written in 2016 from 2015 is primarily attributable to an increase at our reinsurance segment, primarily reflecting $854.3 million of premiums in 2016 related to a large whole account quota share treaty entered into in the fourth quarter of 2015, or the “Quota Share Treaty,” compared with $221.6 million of such premiums in 2015, partially offset by the impact of changes in foreign exchange rates.
Net premiums written in 2015 approximated net premiums written in 2014, as a slight decrease at our reinsurance segment was largely offset by an increase at our insurance segment. Net premiums written at our reinsurance segment decreased in 2015 from 2014 as a result of higher ceded premiums written due to an increase in reinsurance coverage purchased by TransRe in 2015.
The decrease in net premiums earned in 2015 from 2014 reflects a decrease at our reinsurance segment, partially offset by an increase at our insurance segment. The decrease in net premiums earned at our reinsurance segment primarily reflects the impact of changes in foreign exchange rates, reduced participation in or non-renewal of certain treaties, reductions in pricing and higher ceded premiums earned due to an increase in reinsurance coverage purchased by TransRe in 2015. In addition, there were no net premiums earned in 2015 related to the Quota Share Treaty. The increase at our insurance segment reflects significant growth at PacificComp and CapSpecialty, partially offset by a decrease at RSUI.
A comparison of net loss and LAE by segment for 2016, 2015 and 2014 is more fully described in the following pages.
Commissions, brokerage and other underwriting expenses. The following table summarizes our consolidated commissions, brokerage and other underwriting expenses.
2015 vs 2014. Commissions, brokerage and other underwriting expenses in 2015 approximated commissions, brokerage and other underwriting expenses from 2014, reflecting a decrease at our reinsurance segment, offset by an increase at our insurance segment. The decrease at our reinsurance segment primarily reflects the impact of lower net premiums earned, as discussed above, partially offset by higher commission rates and employee-related overhead expenses. The increase at our insurance segment primarily reflects the impact of higher net premiums earned, as discussed above.
2016 vs 2015. The decrease in underwriting profit in 2016 from 2015 reflects a decrease at our reinsurance segment due primarily to higher catastrophe and non-catastrophe losses in the current accident year, partially offset by an increase in favorable prior accident year loss reserve development, all as discussed above.
2015 vs 2014. The decrease in underwriting profit in 2015 from 2014 reflects a decrease at our reinsurance and insurance segments. The decrease in underwriting profit at our reinsurance segment primarily reflects the impact of lower net premiums earned, partially offset by lower catastrophe losses and more favorable prior year loss reserve development, all as discussed above. The decrease in underwriting profit at our insurance segment primarily reflects less favorable prior year loss reserve development and higher current year losses, partially offset by lower catastrophe losses, all as discussed above.
2016 vs 2015. Net investment income in 2016 approximated net investment income in 2015, primarily reflecting lower dividend income and lower income from other invested assets, offset by higher interest income from funds withheld by cedants. Interest income was reduced in the fourth quarter of 2016 by approximately $7 million of adjustments made to more accurately reflect premium amortization associated with certain bonds.
2015 vs 2014. The decrease in net investment income in 2015 from 2014 primarily reflects lower dividends from common stocks in our equity securities portfolio, lower interest income and lower earnings from other invested assets. The decrease in dividends is due primarily to a partial restructuring of the equity portfolio during 2015, higher realized gains and lower dividend income in 2015. The decrease in interest income is due primarily to lower investible balances and the impact of changes in foreign exchange rates.
A comparison of investment results for 2016, 2015 and 2014 is more fully described in the following pages.
Other revenue and expenses. The following table summarizes our consolidated other revenue and expenses.
Other revenue and Other operating expenses. Other revenue and other operating expenses primarily include sales revenues and expenses associated with Alleghany Capital. Other operating expenses also include the long-term incentive compensation of our reinsurance and insurance segments, which totaled $76.1 million, $77.6 million and $83.5 million in 2016, 2015 and 2014, respectively. See Note 14 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information.
The increase in other revenue and other operating expenses in 2016 from 2015 primarily reflects the acquisition of IPS on October 31, 2015, the inclusion of Jazwares in our consolidated results as of April 15, 2016 and, to a lesser extent, growth at Kentucky Trailer.
The increase in other revenue in 2015 from 2014 primarily reflects the acquisition of IPS on October 31, 2015 and, to a lesser extent, growth at Kentucky Trailer. The increase in other operating expenses in 2015 from 2014 primarily reflects the acquisition of IPS and, to a lesser extent, increased expenses at Kentucky Trailer and SORC, partially offset by a decrease in the long-term incentive compensation expense of our reinsurance and insurance segments due to less favorable operating results.
Amortization of intangible assets. Amortization expenses in 2016 reflect the amortization of net intangible assets, including intangible assets related to the acquisitions of IPS and Jazwares. Negative amortization expenses in 2015 and 2014 reflect the amortization of intangible liabilities acquired in the merger with TransRe in 2012, partially offset by the amortization of intangible assets. Amortization of intangible assets in 2015 also reflects the acquisition of IPS on October 31, 2015.
2016 vs 2015. The decreases in earnings before income taxes and net earnings attributable to Alleghany stockholders in 2016 from 2015 primarily reflect lower net realized capital gains and underwriting profits, partially offset by lower OTTI losses, all as discussed above.
(3) The loss ratio is derived by dividing the amount of net loss and LAE by net premiums earned, all as determined in accordance with GAAP.
Casualty & other. The increase in gross premiums written in 2016 from 2015 primarily reflects $501.1 million of casualty-related premiums in 2016 compared with $156.9 million in 2015 related to the Quota Share Treaty, partially offset by the impact of changes in foreign exchange rates. Excluding the impact of changes in foreign exchange rates, gross premiums written increased 14.5 percent in 2016 from 2015. The increase in net premiums earned in 2016 from 2015 primarily reflects net premiums earned related to the Quota Share Treaty. There were no net premiums earned in 2015 related to the Quota Share Treaty. Excluding the impact of changes in foreign exchange rates, net premiums earned increased 21.7 percent in 2016 from 2015.
The increase in gross premiums written in 2015 from 2014 reflects $156.9 million of casualty-related premiums recorded on December 31, 2015 related to the Quota Share Treaty, partially offset by the impact of changes in foreign exchange rates. Excluding the impact of changes in foreign exchange rates, gross premiums written in 2015 increased 8.0 percent in 2015 from 2014. The decrease in net premiums earned in 2015 from 2014 reflects the impact of changes in foreign exchange rates. Excluding the impact of changes in foreign exchange rates, net premiums earned increased 1.3 percent in 2015 from 2014. There were no net premiums earned in 2015 related to the Quota Share Treaty.
Reinsurance Segment: Net loss and LAE. The following table summarizes net loss and LAE for the reinsurance segment.
The decrease in net loss and LAE in 2015 from 2014 primarily reflects the impact of lower net premiums earned, lower claims in the current accident year and lower catastrophe losses. Catastrophe losses for 2015 relate to the chemical explosion in Tianjin,
(4) Reflects favorable prior accident year loss reserve development primarily related to the 2011 and 2015 accident years.
The decrease in net loss and LAE in 2015 from 2014 primarily reflects the impact of lower net premiums earned and more favorable prior accident year loss reserve development, partially offset by higher catastrophe losses in 2015. The catastrophe losses in 2015 relate to the chemical explosion in Tianjin, China in August 2015. Net loss and LAE in 2016, 2015 and 2014 include (favorable) unfavorable prior accident year loss reserve development as shown in the table below:
(2) Represents unfavorable prior accident year development on Commuted A&E Liabilities related to the Commutation Agreement, as discussed above.
(3) Generally reflects favorable prior accident year loss reserve development reserves in a variety of casualty & other lines of business primarily from the 2003 through 2015 accident years.
(5) Generally reflects favorable prior accident year loss reserve development in a variety of casualty & other lines of business primarily from the 2003 through 2007 and 2010 through 2011 accident years, partially offset by unfavorable prior accident year loss reserve development from the 2013 accident year and the 2002 and prior accident years.
Property. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of higher net premiums earned, partially offset by a slight decrease in employee-related overhead expenses. The decrease in commissions, brokerage and other underwriting expenses in 2015 from 2014 primarily reflects the impact of lower net premiums earned, partially offset by higher employee-related overhead expenses.
(1) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, OTTI losses, other revenue, other operating expenses, corporate administration, amortization of intangible assets and interest expense. Underwriting profit is a non-GAAP financial measure and does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. See “Comment on Non-GAAP Financial Measures” herein for additional detail on the presentation of our results of operations.
(2) The loss ratio is derived by dividing the amount of net loss and LAE by net premiums earned, all as determined in accordance with GAAP.
CapSpecialty. The increase in gross premiums written in 2016 from 2015 primarily reflects strong growth in the professional, environmental and construction lines of business and, to a lesser extent, an increase in the surety lines of business. The increase in gross premiums written in 2015 from 2014 primarily reflects strong growth in the professional lines of business, partially offset by declines in other property and casualty lines of business and the surety lines of business.
The increase in net premiums earned in 2016 from 2015 primarily reflects increases in gross premiums written in recent quarters. The increase in net premiums earned in 2015 from 2014 primarily reflects an increase in gross premiums written in recent quarters and lower ceded premiums earned due to a reduction in reinsurance coverage in 2015.
PacificComp. The increases in gross premiums written and net premiums earned in 2016 from 2015 and in 2015 from 2014 primarily reflect premium growth due to PacificComp’s distribution initiatives and growth in targeted segments of the workers’ compensation market in the State of California.
Insurance Segment: Net loss and LAE. The following table summarizes net loss and LAE for the insurance segment.
Catastrophe losses in 2016 primarily reflect losses from flooding and severe weather primarily in the State of Texas in April and May, losses from wildfires in Alberta, Canada in May, losses from flooding and severe weather primarily in the State of Louisiana and the Midwestern U.S. in the third quarter, losses from wildfires in the State of Tennessee in November and $26.8 million of losses from Hurricane Matthew, which caused property damage and flooding in the Southeast Coast of the U.S. in October. Catastrophe losses in 2015 primarily reflect several occurrences of severe weather in the Southeastern and Midwestern U.S. Catastrophe losses in 2014 primarily reflect the impact of nationwide severe winter weather in the U.S. in January and February and hail storms in the spring, summer and fall.
Net loss and LAE in 2016, 2015 and 2014 include (favorable) unfavorable prior accident year loss reserve development as shown in the table below:
(3) Primarily reflects favorable prior accident year loss reserve development in the professional liability, general liability and umbrella/excess lines of business, and primarily related to the 2006 through 2010 accident years, partially offset by unfavorable prior accident year loss reserve development in the directors’ and officers’ liability lines of business in the 2011 and 2012 accident years.
(6) Primarily reflects favorable prior accident year development on unallocated LAE reserves and prior year catastrophe loss reserves from recent accident years.
The favorable prior accident year loss reserve development in 2016 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The unfavorable prior accident year loss reserve development in 2015 and 2014 reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods. The favorable prior accident year loss reserve development in 2016 did not impact assumptions used in estimating CapSpecialty’s loss and LAE liabilities for business earned in 2016.
The favorable prior accident year loss reserve development in 2016 related primarily to the 2012 and prior accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The unfavorable prior accident year loss reserve development in 2014 related primarily to the 2009 and prior accident years, and reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods.
RSUI. The decrease in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of lower net premiums earned and relatively stable overhead expenses. The slight increase in commissions, brokerage and other underwriting expenses in 2015 from 2014 primarily reflects higher commissions and higher employee-related benefit and compensation costs, partially offset by the impact of lower net premiums earned. Higher commissions reflect the impact of RSUI’s binding authority lines of business, which incurs a higher commission rate than RSUI’s other lines of business, being a higher portion of RSUI’s overall book of business in 2015.
CapSpecialty. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of higher net premiums earned and relatively stable overhead expenses. The slight increase in commissions, brokerage and other underwriting expenses in 2015 from 2014 primarily reflects the impact of higher overall net premiums earned, partially offset by a decline in the portion of CapSpecialty’s overall book of business comprising of CapSpecialty’s surety lines of business, which incur a higher commission rate than CapSpecialty’s other lines of business.
PacificComp. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of higher net premiums earned and relatively stable overhead expenses, partially offset by the deferral of certain acquisition costs for new business commencing in 2016. The increase in commissions, brokerage and other underwriting expenses in 2015 from 2014 primarily reflect the impact of growth in net premiums earned.
Insurance Segment: Underwriting profit. The following table summarizes our underwriting profit for the insurance segment.
RSUI. The decrease in underwriting profit in 2016 from 2015 primarily reflects higher catastrophe losses and the impact of lower net premiums earned, partially offset by an increase in favorable prior accident year loss reserve development, all as discussed above. The decrease in underwriting profit in 2015 from 2014 primarily reflects less favorable prior accident year loss reserve development, a higher current accident year loss ratio for the casualty lines of business and the impact of lower net premiums earned, partially offset by lower catastrophe losses, all as discussed above.
The decrease in net investment income in 2015 from 2014 primarily reflects lower dividends from common stocks in our equity securities portfolio, lower interest income and lower earnings from other invested assets. The decrease in dividends is due primarily to a partial restructuring of the equity portfolio during 2015, which resulted in several changes to our equity security holdings, higher realized gains and lower dividend income in 2015. The decrease in interest income is due primarily to lower investible balances and the impact of changes in foreign exchange rates.
The increase in net realized capital gains in 2015 from 2014 primarily reflects higher gains from the equity securities portfolio, partially offset by lower gains for the debt securities portfolio. Realized capital gains in 2015 include the sales of certain equity securities resulting from a partial restructuring of the equity portfolio and the sales of certain equity securities which had their cost basis reduced in earlier periods for the recognition of OTTI losses. Realized capital gains in 2014 include a realized capital gain of $34.0 million from the sales of long-dated U.S. Treasury Strip debt securities in April 2014, some additional realized capital gains taken on debt securities and a $9.4 million realized capital loss on the early redemption of $300 million par value of the 2015 Senior Notes.
See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on gross unrealized investment losses for debt and equity securities as of December 31, 2016.
Alleghany Capital consists of: (i) manufacturing and service operations conducted through Bourn & Koch, Kentucky Trailer, IPS and Jazwares; (ii) oil and gas operations, conducted through SORC and included Alleghany Capital’s investment in ORX until we sold it on December 23, 2016; and (iii) corporate operations and investments at the Alleghany Capital level. In July 2014, Alleghany Capital acquired a 30 percent equity interest in Jazwares. On April 15, 2016, Alleghany Capital acquired an additional 50 percent of Jazwares’ outstanding equity, bringing its equity ownership interest to 80 percent and, as of that date, the results of Jazwares have been included in our consolidated results. Prior to April 15, 2016, Jazwares was accounted for under the equity method of accounting. In October 2015, Alleghany Capital acquired a majority interest in IPS. ORX was accounted for under the equity method of accounting.
The results of Alleghany Capital for 2016, 2015 and 2014 are presented below.
(2) Includes for 2016 the purchase of an additional 50 percent of Jazwares’ outstanding equity on April 15, 2016.
Net investment income. The decrease in net investment income in 2016 from 2015 primarily reflects a cessation of equity method income from Jazwares upon our acquisition of a majority interest on April 15, 2016 and losses on other invested assets in 2016, partially offset by the absence of losses from ORX in 2016. The increase in net investment income in 2015 from 2014 primarily reflects higher equity method income from Jazwares, partially offset by increased losses from ORX.
Net realized capital gains. Net realized capital losses in 2016 primarily reflect a $98.8 million capital loss due to an impairment charge from a write-down of certain SORC assets, partially offset by a gain of $13.2 million recognized by Alleghany Capital on April 15, 2016 in connection with its acquisition of an additional 50 percent equity ownership in Jazwares, when its pre-existing 30 percent equity ownership was remeasured at estimated fair value, or the “Jazwares Remeasurement Gain.”
The primary components of corporate activities are Alleghany Properties and activities at the Alleghany parent company. The following table summarizes the results for corporate activities.
Net realized capital gains. Net realized capital losses in 2016 primarily reflect the sale at a loss of equity securities in the mining and health care sectors. Net realized capital losses in 2015 primarily reflect the sale at a loss of equity securities in the energy sector. Net realized capital gains in 2014 primarily reflect gains from the sale of equity securities.
Other revenue. The increases in other revenue in 2016 from 2015 and 2015 from 2014 primarily reflect a gain on the sale of a retail shopping center by Alleghany Properties in 2016, and a modest gain on a sale recorded by Alleghany Properties in 2015.
Corporate administration. The decrease in corporate administration expense in 2016 from 2015 primarily reflects lower long-term incentive compensation expense accruals due mainly to the impact of less favorable financial results, partially offset by the impact of an increase in the price per share of our common stock during 2016. Corporate administration expense in 2015 approximated corporate administration expense from 2014.
Interest expense. Interest expense in 2016 approximated interest expense in 2015. The increase in interest expense in 2015 from 2014 is due to the issuance of the 2044 Senior Notes (as defined on page 107 of this Form 10-K) on September 9, 2014.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2015 and December 31, 2014. Gross and net loss and LAE reserves as of December 31, 2015 decreased from December 31, 2014, reflecting a decrease in our reinsurance segment loss and LAE reserves, partially offset by an increase at our insurance segment. The decrease in gross and net loss and LAE reserves at our reinsurance segment primarily reflects favorable prior accident year loss reserve development, loss payments including amounts related to commutations in the fourth quarter of 2015 with certain cedants and the impact of changes in foreign currency exchange rates. The increase in gross and net loss and LAE reserves at our insurance segment primarily reflects higher current accident year losses.
We had no allowance for uncollectible reinsurance as of December 31, 2016.
Our insurance operating subsidiaries provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and as a result, these claims can have a very long claim tail, occasionally extending for decades. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long-tail casualty lines of business, estimating the ultimate liabilities for unpaid loss and LAE is a more complex process and depends on a number of factors, including the line and volume of the business involved. For these reasons, our insurance operating subsidiaries will generally use actuarial projections in setting reserves for all casualty lines of business.
We believe that the reserves for unpaid loss and LAE established by our reinsurance and insurance subsidiaries are adequate as of December 31, 2016; however, additional reserves, which could have a material impact upon our financial condition, results of operations and cash flows, may be necessary in the future.
Expected Loss Ratio Method: expected loss ratios are applied to premiums earned, based on historical company experience, or historical insurance industry results when company experience is deemed not to be sufficient; and
Reported and paid loss emergence patterns represent management’s expectation of how losses will be reported and ultimately paid in the future based on the historical emergence patterns of reported and paid losses and are derived from past experience of our subsidiaries, modified for current trends. These emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value.
Loss Frequency and Severity. Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described above. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs, changes in economic conditions or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to our reinsurance or insurance operating subsidiary. The length of the loss reporting lag affects their ability to accurately predict loss frequency, which are more predictable for lines with short reporting lags, as well as the amount of reserves needed for IBNR. If the actual level of loss frequency and severity is higher or lower than expected, the ultimate losses will be different than management’s estimates. A small percentage change in an estimate can result in a material effect on our reported earnings. The following table reflects the impact of changes, which could be favorable or unfavorable, in frequency and severity on our loss estimates for claims occurring in 2016:
Prior Year Development. Our reinsurance and insurance subsidiaries continually evaluate the potential for changes, both favorable and unfavorable, in their estimates of loss and LAE liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid loss and LAE established in prior years, these liabilities are periodically analyzed and their expected ultimate cost adjusted, where necessary, to reflect favorable or unfavorable development in loss experience and new information, including, for certain catastrophic events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid loss and LAE, both favorable and unfavorable, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior accident year reserve development. We adjusted our prior year loss and LAE reserve estimates during 2016, 2015 and 2014 based on current information that differed from previous assumptions made at the time such loss and LAE reserves were previously estimated. The (favorable) unfavorable prior accident year loss reserve development for 2016, 2015 and 2014 is summarized as follows:
(8) Represents unfavorable prior accident year development on Commuted A&E Liabilities related to the Commutation Agreement, as discussed above.
(14) Primarily reflects favorable prior accident year loss reserve development in the professional liability, general liability and umbrella/excess lines of business, and primarily related to the 2006 through 2010 accident years, partially offset by unfavorable prior accident year loss reserve development in the directors’ and officers’ liability lines of business in the 2011 and 2012 accident years.
(20) Primarily reflects favorable prior accident year loss reserve development related to the 2012 and prior accident years.
(21) Primarily reflects unfavorable prior accident year loss reserve development related to the 2009 and prior accident years.
Asbestos-Related Illness and Environmental Impairment Reserves. Loss and LAE include amounts for risks relating to asbestos-related illness and environmental impairment. The reserves carried for such claims, including the IBNR portion, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illness and environmental impairment losses, particularly for those occurring in 1985 and prior, which, before the Commutation Agreement, represented the majority of TransRe’s asbestos-related illness and environmental impairment reserves. This uncertainty is due to inconsistent and changing court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible future changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings. Although we are unable at this time to determine whether additional reserves, which could have a material adverse effect upon our results of operations, may be necessary in the future, we believe that our asbestos-related illness and environmental impairment reserves are adequate as of December 31, 2016. See Note 12(c) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” and pages 41 and 42 of this Form 10-K for additional information on loss and LAE for risks relating to asbestos-related illness and environmental impairment.
Mortgage-backed and asset-backed securities are initially valued at the transaction price. Subsequently, we use widely accepted valuation practices that produce a fair value measurement. The vast majority of fair values are determined using an income approach. The income approach primarily involves developing a discounted cash flow model using the future projected cash flows of the underlying collateral, as well as other inputs described below. A few Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage-backed and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained, and as such, an income approach is not feasible.
We then evaluate those equity securities where the unrealized loss is at least 20 percent of cost as of the balance sheet date or that have been in an unrealized loss position continuously for six months or more preceding the balance sheet date. This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other than temporarily impaired including: (i) market valuation metrics associated with the equity security (such as dividend yield and price-to-earnings ratio); (ii) current views on the equity security, as expressed by either our internal stock analysts and/or by third-party stock analysts or rating agencies; and (iii) credit or news events associated with a specific issuer, such as negative news releases and rating agency downgrades with respect to the issuer of the equity security.
Debt securities in an unrealized loss position are evaluated for OTTI if they meet any of the following criteria: (i) they are trading at a discount of at least 20 percent to amortized cost for an extended period of time (nine consecutive months or more); (ii) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; or (iii) we intend to sell or it is more likely than not that we will sell the debt security before recovery of its amortized cost basis.
General. In general, we follow a policy of maintaining a relatively liquid financial condition at our unrestricted holding companies. This policy has permitted us to expand our operations through internal growth at our subsidiaries and through acquisitions of, or substantial investments in, operating companies. As of December 31, 2016, we held total marketable securities and cash of $1,047.4 million, compared with $821.3 million as of December 31, 2015. The increase in 2016 primarily reflects the receipt of dividends from TransRe and RSUI, partially offset by repurchases of shares of our common stock, capital contributions to Alleghany Capital for the additional investment in Jazwares and capital contributions to SORC, a capital contribution to PacificComp and our investment in certain private equity investments, all as further described below. The $1,047.4 million is comprised of $460.6 million at the Alleghany parent company, $504.0 million at AIHL and $82.8 million at the TransRe holding company. We also hold certain non-marketable investments at our unrestricted holding companies. We believe that we have and will have adequate internally generated funds, cash resources and
unused credit facilities to provide for the currently foreseeable needs of our business, and we had no material commitments for capital expenditures as of December 31, 2016.
Stockholders’ equity attributable to Alleghany stockholders was approximately $7.9 billion as of December 31, 2016, compared with approximately $7.6 billion as of December 31, 2015. The increase in stockholders’ equity in 2016 primarily reflects net earnings, partially offset by a decrease in unrealized appreciation on our debt securities portfolio and repurchases of our common stock. The decrease in unrealized appreciation on our debt securities portfolio is due to an increase in longer-term interest rates that occurred in 2016. As of December 31, 2016, we had 15,410,164 shares of our common stock outstanding, compared with 15,544,077 shares of our common stock outstanding as of December 31, 2015.
Debt. On September 9, 2014, we completed a public offering of $300.0 million aggregate principal amount of our 4.90% senior notes due on September 15, 2044, or the “2044 Senior Notes.” The 2044 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest on the 2044 Senior Notes is payable semi-annually on March 15 and September 15 of each year. The terms of the 2044 Senior Notes permit redemption prior to their maturity. The indenture under which the 2044 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2044 Senior Notes were issued at approximately 99.3 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $294.3 million and an effective yield of approximately 5.0 percent.
Credit Agreement. On October 15, 2013, we entered into a four-year credit agreement, or the “Credit Agreement” which provides for an unsecured credit facility in an aggregate principal amount of up to $200.0 million. The Credit Agreement is scheduled to terminate on October 15, 2017, unless terminated at an earlier date. Borrowings under the Credit Agreement will be available for working capital and general corporate purposes.
The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement requires us to, among other things, (x) maintain consolidated net worth of not less than the sum of (i) $4,223.9 million plus (ii) 50 percent of our cumulative consolidated net earnings in each fiscal quarter thereafter (if positive) commencing on September 30, 2013, and (y) maintain a ratio of consolidated total indebtedness to consolidated capital as of the end
of each fiscal quarter of not greater than 0.35 to 1.0. Additionally, the Credit Agreement contains various negative covenants with which we must comply, including, but not limited to, limitations respecting: the creation of liens on any property or asset; the incurrence of indebtedness; mergers, consolidations, liquidations and dissolutions; change of business; sales of assets; transactions with affiliates; anti-terrorism laws and foreign asset control regulations and other provisions customary in similar types of agreements.
If an Event of Default occurs under the Credit Agreement, then, to the extent permitted in the Credit Agreement, the lenders may direct the administrative agent to, or the administrative agent may, with the consent of lenders holding more than 50 percent of the aggregate outstanding principal amount of the loans, as applicable, terminate the commitments, accelerate the repayment of any outstanding loans and exercise all rights and remedies available to such lenders under the Credit Agreement and applicable law. In the case of an Event of Default that exists due to the occurrence of certain involuntary or voluntary bankruptcy, insolvency or reorganization events of ours, the commitments will automatically terminate and the repayment of any outstanding loans shall be automatically accelerated.
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2016, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows:
(1) “Senior Notes” refers to: (i) the Alleghany Senior Notes, consisting of the 2020 Senior Notes, the 2022 Senior Notes and the 2044 Senior Notes; and (ii) TransRe’s 8.00% senior notes due on November 30, 2039. See Note 8 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for further details on the Senior Notes and other debt.
In July 2013, AIHL invested $250.0 million in Ares Management LLC, or “Ares,” an asset manager, in exchange for a 6.25 percent equity stake in Ares, with an agreement to engage Ares to manage up to $1.0 billion in certain investment strategies. In May 2014, Ares completed an initial public offering of its common units. Upon completion of the initial public offering, Alleghany’s equity investment in Ares converted to limited partner interests in certain Ares subsidiaries that are convertible into an aggregate 5.9 percent interest in Ares common units. These interests may be converted at any time at our discretion. Until we determine to convert our limited partner interests into Ares common units, we classify our investment in Ares as a component of other invested assets and we account for our investment using the equity method of accounting. As of December 31, 2016, AIHL’s carrying value in Ares was $224.0 million, which is net of returns of capital received from Ares.
Energy Holdings. As of December 31, 2016, we had holdings in energy sector businesses of $871.1 million, comprised of $313.3 million of debt securities, $408.6 million of equity securities and $149.2 million of our equity attributable to SORC.
With respect to our non-insurance operating subsidiaries, SORC has relied on Alleghany almost entirely to support its operations. From its formation in 2011 through December 31, 2016, we have invested $269.2 million in SORC, of which $128.6 million was invested in SORC’s acquisition of certain legacy oil fields for the sole purpose of applying enhanced oil recovery techniques.
due to catastrophe losses. Our consolidated investment portfolio currently consists mainly of highly rated and liquid debt and equity securities listed on national securities exchanges. The overall credit quality of the debt securities portfolio is measured using the lowest rating of S&P, Moody’s or Fitch. In this regard, the overall weighted-average credit quality rating of our debt securities portfolio as of December 31, 2016 and 2015 was AA-. Although many of our debt securities, which consist predominantly of municipal bonds, are insured by third-party financial guaranty insurance companies, the impact of such insurance was not significant to the debt securities credit quality rating as of December 31, 2016. As of December 31, 2016, the ratings of our debt securities portfolio were as follows:
(1) Consists of $284.1 million of securities rated BB / Ba, $185.7 million of securities rated B, $57.1 million of securities rated CCC, $2.0 million of securities rated CC, $4.0 million of securities rated below CC and $127.0 million of not-rated securities.
Effective duration measures a portfolio’s sensitivity to changes in interest rates. In this regard, as of December 31, 2016, our debt securities portfolio had an effective duration of approximately 4.5 years compared with 4.6 years as of December 31, 2015. As of December 31, 2016, approximately $3.5 billion, or 27.0 percent, of our debt securities portfolio represented securities with maturities of five years or less. See Note 4(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on the contractual maturities of our consolidated debt securities portfolio. We may increase the proportion of our debt securities portfolio held in securities with maturities of more than five years should the yields of these securities provide, in our judgment, sufficient compensation for their increased risk. We do not believe that this strategy would reduce our ability to meet ongoing claim payments or to respond to significant catastrophe losses.
Fair Value. The carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2016 and 2015 were as follows:
In addition to such procedures, we review the reasonableness of our classification of securities within the three-tiered hierarchy to ensure that the classification is consistent with GAAP.
Projections of potential catastrophe losses are typically expressed in terms of the probable maximum loss, or “PML.” We define PML as our anticipated maximum loss (taking into account contract limits) caused by a single catastrophe event at a specified estimated return period affecting a broad contiguous area. These modeled losses are estimated based upon contracts in force at January 1, 2017 for TransRe and December 1, 2016 for RSUI and PacificComp. Modeled results also reflect losses arising from certain of our invested assets that have specific catastrophe exposures.
catastrophe events more frequently than the modeled probabilities would suggest. In any given year, catastrophe events could have a material adverse effect on our financial condition, results of operations, cash flows and liquidity.
In April 2015, the FASB issued guidance that requires debt issuance costs related to debt liabilities be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, which is consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected. This guidance was effective in the first quarter of 2016. We adopted this guidance on a retrospective basis in the first quarter of 2016 and the implementation resulted in a reduction of other assets and a corresponding decrease in Senior Notes and other debt of approximately $7 million as of March 31, 2016 and December 31, 2015.
In May 2015, the FASB issued guidance that requires disclosures related to short-duration insurance contracts. The guidance applies to property and casualty insurance and reinsurance entities, among others, and requires the following annual disclosure related to the liability for loss and LAE: (i) net incurred and paid claims development information by accident year for up to ten years; (ii) a reconciliation of incurred and paid claims development information to the aggregate carrying amount of the liability for loss and LAE; (iii) IBNR liabilities by accident year and in total; (iv) a description of reserving methodologies (as well as any changes to those methodologies); (v) quantitative information about claim frequency by accident year; and (vi) the average annual percentage payout of incurred claims by age by accident year. In addition, the guidance requires insurance entities to disclose for annual and interim reporting periods a roll-forward of the liability for loss and LAE. This guidance is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016, with early adoption permitted. We have adopted this guidance as of December 31, 2016 and the implementation did not have an impact on our results of operations and financial condition. See Note 1(k) and Note 6 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K, for the new disclosures.
We have audited the accompanying consolidated balance sheets of Alleghany Corporation and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Although Alleghany’s primary sources of revenues and earnings are its reinsurance and insurance operations and investments, Alleghany also sources, executes, manages and monitors certain private capital investments primarily through its wholly-owned subsidiary Alleghany Capital Corporation (“Alleghany Capital”). Alleghany Capital’s investments are included in other activities for segment reporting purposes and include:
R.C. Tway Company, LLC (“Kentucky Trailer”), a manufacturer of custom trailers and truck bodies for the moving and storage industry and other markets, headquartered in Louisville, Kentucky;
The results of IPS have been included in Alleghany’s consolidated results beginning with its acquisition by Alleghany Capital on October 31, 2015. On April 15, 2016, Alleghany Capital acquired an additional 50 percent of Jazwares’ outstanding equity, bringing its equity ownership interest to 80 percent and, as of that date, the results of Jazwares have been included in Alleghany’s consolidated results. Prior to April 15, 2016, Jazwares was accounted for under the equity method of accounting. In addition, Alleghany owns and manages properties in the Sacramento, California region through its wholly-owned subsidiary Alleghany Properties Holdings LLC (“Alleghany Properties”). Alleghany owned an approximately 15 percent equity interest in ORX Exploration, Inc. (“ORX”), a regional oil and gas exploration and production company, until it was sold on December 23, 2016. Alleghany’s public equity investments are managed primarily through Alleghany’s wholly-owned subsidiary Roundwood Asset Management LLC.
as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Alleghany relies on historical experience and on various other assumptions that it believes to be reasonable under the circumstances to make judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from those reported results to the extent that those estimates and assumptions prove to be inaccurate. Changes in estimates are reflected in the consolidated statement of earnings and comprehensive income in the period in which the changes are made.
AFS securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect, applicable to AFS securities, as well as partnership investments that Alleghany accounts for as AFS, are excluded from earnings and reflected in comprehensive income, and the cumulative effect is reported as a separate component of stockholders’ equity until realized. If a decline in fair value is deemed to be other than temporary, the investment is written down to its fair value and the amount of the write-down is recorded as an other than temporary impairment (“OTTI”) loss on the statement of earnings. In addition, any portion of such decline related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than against earnings.
Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between willing, able and knowledgeable market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, a three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs are the reporting entity’s own assumptions about market participant assumptions based on the best information available under the circumstances. In assessing the appropriateness of using observable
inputs in making its fair value determinations, Alleghany considers whether the market for a particular security is “active” or not based on all the relevant facts and circumstances. A market may be considered to be inactive if there are relatively few recent transactions or if there is a significant decrease in market volume. Furthermore, Alleghany considers whether observable transactions are “orderly” or not. Alleghany does not consider a transaction to be orderly if there is evidence of a forced liquidation or other distressed condition; as such, little or no weight is given to that transaction as an indicator of fair value.
Level 2: Valuations are based on direct and indirect observable inputs other than quoted market prices included in Level 1. Level 2 inputs include quoted prices for similar assets in active markets and inputs other than quoted prices that are observable for the asset, such as the terms of the security and market-based inputs. Terms of the security include coupon, maturity date and any special provisions that may, for example, enable the investor, at its election, to redeem the security prior to its scheduled maturity date (such provisions may apply to all debt securities except U.S. Government obligations). Market-based inputs include interest rates and yield curves that are observable at commonly quoted intervals and current credit rating(s) of the security. Market-based inputs may also include credit spreads of all debt securities except U.S. Government obligations, and currency rates for certain foreign government obligations and foreign corporate bonds denominated in foreign currencies. Fair values are determined using a market approach that relies on the securities’ relationships to quoted prices for similar assets in active markets, as well as the other inputs described above. In determining the fair values for the vast majority of commercial mortgage-backed securities (“CMBS”) and other asset- backed securities, as well as a small portion of residential mortgage-backed securities (“RMBS”), an income approach is used to corroborate and further support the fair values determined by the market approach. The income approach primarily involves developing a discounted cash flow model using the future projected cash flows of the underlying collateral, and the terms of the security. Level 2 assets generally include short-term investments and most debt securities. Alleghany’s Level 2 liabilities consist of the Senior Notes, as defined in Note 1(n).
Level 3: Valuations are based on techniques that use significant inputs that are unobservable. The valuation of Level 3 assets requires the greatest degree of judgment. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Alleghany’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, Alleghany considers factors specific to the asset. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assets classified as Level 3 principally include certain RMBS, CMBS, other asset-backed securities (primarily, collateralized loan obligations), U.S. corporate bonds, partnership investments and non-marketable equity investments.
Fair values for partnership and non-marketable equity investments are initially valued at the transaction price. Subsequently, fair value is based on the performance of the portfolio of investments or results of operations of the investee, as derived from their financial statements. Significant improvements or disruptions in the financial markets may result in directionally similar or opposite changes to the portfolio of the investee, depending on how management of the investee has correlated the portfolio of investments to the market. Also, any changes made by the investee to the investment strategy of the non-marketable equity investments could result in significant changes to fair value that have a positive or negative correlation to the performance observed in the equity markets. For those investments whose performance is based on the results of operations within a specific industry, significant events impacting that industry could materially impact fair value. Also, decisions and changes to strategy made by management of the investee could result in positive or negative outcomes, which could significantly impact the results of operations of the investee and subsequently fair value.
written based on contract terms for excess-of-loss treaty contracts. Premiums are earned ratably over the terms of the related coverages.
The reserves for loss and LAE include but are not limited to: (i) reports and individual case estimates received from ceding companies with respect to assumed reinsurance business; (ii) the accumulation of individual estimates for claims reported with respect to direct insurance business; (iii) estimates for IBNR claims based on past experience, modified for current trends and industry data; and (iv) estimates of expenses for investigating and settling claims based on past experience. The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any adjustments are reflected in current
income. Net loss and LAE consist of the estimated ultimate cost of settling claims incurred within the reporting period (net of related reinsurance recoverable), including IBNR claims, plus changes in estimates of prior period losses.
While the reserving process is difficult for the insurance business, the inherent uncertainties of estimating loss reserves are even greater for the reinsurance business, due primarily to the longer-term nature of most of the business, the diversity of development patterns among different types of reinsurance contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which may change without notice. TransRe writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business. Claims from such classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict. Net loss and LAE also include amounts for risks relating to asbestos-related illness and environmental impairment.
As noted above, as of any balance sheet date, not all claims that have occurred have been reported to us, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled is referred to as the “claim tail.” Reported losses for the shorter-tailed classes, such as property, generally reach the ultimate level of incurred losses in a relatively short period of time and as such, are only relevant for the more recent accident years.
Noninsurance revenues and related operating expenses arising from the sale of manufactured goods and services is generally recognized as the transfer of goods and services to customers takes place. Noninsurance revenues reflect the payment or payments that are expected to be received from the customers for those goods and services.
Certain prior year amounts have been reclassified to conform to the 2016 presentation of the financial statements.
In February 2015, the Financial Accounting Standards Board (the “FASB”) issued guidance that amended the analysis that must be performed to determine whether an entity should consolidate certain types of legal entities. Under this guidance, the evaluation of whether limited partnerships and similar entities are variable interest entities or voting interest entities is modified, the presumption that general partners should consolidate limited partnerships is eliminated and the process to determine the primary beneficiary of a variable interest entity is modified. This guidance was effective in the first quarter of 2016. Alleghany adopted this guidance in the first quarter of 2016 and the implementation did not have a material impact on Alleghany’s results of operations and financial condition.
In May 2014, the FASB, together with the International Accounting Standards Board, issued guidance on the recognition of revenue from contracts with customers. Under this guidance, revenue is recognized as the transfer of goods and services to customers takes place and in amounts that reflect the payment or payments that are expected to be received from the customers for those goods and services. This guidance also requires new disclosures about revenue. Revenues related to insurance and reinsurance are not impacted by this guidance. In July 2015, the FASB determined that it would delay the effective date of the new revenue standard by a year. This guidance is now effective in the first quarter of 2018 for public entities, with early adoption permitted in 2017. Alleghany will adopt this guidance in the first quarter of 2018 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
In January 2016, the FASB issued guidance that changes the recognition and measurement of certain financial instruments. This guidance requires investments in equity securities (except those accounted for under the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income. For equity securities that do not have readily determinable fair values, measurement may be at cost, adjusted for any impairment and changes resulting from observable price changes for a similar investment of the same issuer. This guidance also changes the presentation and disclosure of financial instruments by: (i) requiring that financial instrument disclosures of fair value use the exit price notion; (ii) requiring separate presentation of financial assets and financial liabilities by measurement category and form, either on the balance sheet or the accompanying notes to the financial statements; (iii) requiring separate presentation in other comprehensive income for the portion of the change in a liability’s fair value resulting from instrument-specific credit risk when an election has been made to measure the liability at fair value; and (iv) eliminating the requirement to disclose the methods and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet. This guidance is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Except for the change in presentation for instrument-specific credit risk, this guidance does not permit early adoption. Alleghany will adopt this guidance in the first quarter of 2018. As of January 1, 2018, unrealized gains or losses of equity securities, net of deferred taxes, will be reclassified from accumulated other comprehensive income to retained earnings. Subsequently, all changes in unrealized gains or losses of equity securities, net of deferred taxes, will be presented in the consolidated statement of earnings, rather than the consolidated statement of comprehensive income. Alleghany does not currently believe that the implementation will have a material impact on its financial condition.
In February 2016, the FASB issued guidance on leases. Under this guidance, a lessee is required to recognize assets and liabilities for leases with terms of more than one year, whereas under current guidance, a lessee is only required to recognize assets and liabilities for those leases qualifying as capital leases. This guidance also requires new disclosures about the amount, timing and uncertainty of cash flows arising from leases. The accounting by lessors is to remain largely unchanged. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. Alleghany will adopt this guidance in the first quarter of 2019 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition. See Note 12(b) for further information on Alleghany’s leases.
In June 2016, the FASB issued guidance on credit losses. Under this guidance, a company is required to measure all expected credit losses on loans, reinsurance recoverables and other financial assets accounted for at cost or amortized cost, as applicable. Estimates of expected credit losses are to be based on historical experience, current conditions and reasonable and supportable forecasts. Credit losses for securities accounted for on an AFS basis are to be measured in a manner similar to GAAP as currently applied and cannot exceed the amount by which fair value is less than the amortized cost. Credit losses for all financial assets are to be recorded through an allowance for credit losses. Subsequent reversals in credit loss estimates are permitted and are to be recognized in earnings. This guidance also requires new disclosures about the significant estimates and judgments used in estimating credit losses, as well as the credit quality of financial assets. This guidance is effective in the first quarter of 2020 for public entities, with early adoption permitted. Alleghany will adopt this guidance in the first quarter of 2020 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
future profitability. In connection with the acquisition, $130.0 million, $52.4 million and $89.7 million of goodwill, indefinite-lived intangible assets and finite-lived intangible assets, respectively, were recorded. Indefinite-lived intangible assets relate to trade name and finite-lived intangible assets relate to license agreements, customer relationships and owned content.
The amount of goodwill and intangible assets, net of accumulated amortization expense, reported on Alleghany’s consolidated balance sheets as of December 31, 2016 and 2015 were as follows:
Trade names and state and foreign insurance licenses have an indefinite useful life. The economic useful lives of significant intangible assets in the reinsurance and insurance segments are as follows: agency relationships - 15 years; brokerage and reinsurance relationships - 15 years; renewal rights - between five and 14 years; loss and LAE reserves - 15 years; leases - 10 years; and internally developed software - 2.5 years. The economic useful life of license agreements is 8 years.
The carrying values and estimated fair values of Alleghany’s consolidated financial instruments as of December 31, 2016 and 2015 were as follows:
Alleghany’s financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2016 and 2015 were as follows:
In 2016, there were transfers of $20.2 million of securities out of Level 3 that were principally due to an increase in observable inputs related to the valuation of such assets and, specifically, an increase in broker quotes. Of the $20.2 million of transfers, $8.6 million related to U.S. corporate bonds, $5.8 million related to CMBS and $5.8 million related to several other types of securities.
The following tables present reconciliations of the changes during 2016 and 2015 in Level 3 assets measured at fair value:
The amortized cost or cost and the fair value of AFS securities as of December 31, 2016 and 2015 are summarized as follows:
The amortized cost or cost and the estimated fair value of debt securities by contractual maturity as of December 31, 2016 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The proceeds from sales of AFS securities were $7.0 billion, $9.6 billion and $6.6 billion in 2016, 2015 and 2014, respectively.
The SORC assets that were written-down relate specifically to SORC’s acquisition of a certain legacy oil field for the sole purpose of applying enhanced oil recovery techniques. After completing construction of its underground facility in 2014, SORC commenced its drilling program in 2015. The drilling program, however, was delayed by third-party equipment problems that have since been corrected as well as a longer than expected trial-and-error process determining the optimum well completion technique for
Realized capital gains from equity securities in 2015 include the sales of certain equity securities resulting from a partial restructuring of the equity portfolio, the sales of certain equity securities which had their cost basis reduced in earlier periods for the recognition of OTTI losses, and a $25.8 million capital loss due to an impairment charge related to a write-off of Alleghany’s investment in ORX. Net realized capital gains in 2014 include a realized capital gain of $34.0 million from the sales of long-dated U.S. Treasury Strip debt securities in April 2014, some additional realized capital gains taken on debt securities and a $9.4 million realized capital loss on the early redemption of $300 million par value of TransRe’s 5.75% senior notes due on December 14, 2015 (the “2015 Senior Notes”). See Note 8(b) for additional information on the early redemption of the 2015 Senior Notes.
The amount of gross realized capital gains and gross realized capital losses in 2016, 2015 and 2014 were as follows:
Alleghany then evaluates those equity securities where the unrealized loss is at least 20 percent of cost as of the balance sheet date or that have been in an unrealized loss position continuously for six months or more preceding the balance sheet date. This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other than temporarily impaired including: (i) market valuation metrics associated with the equity security (such as dividend yield and price-to-earnings ratio); (ii) current views on the equity security, as expressed by either Alleghany’s internal stock analysts and/or by third-party stock analysts or rating agencies; and (iii) credit or news events associated with a specific issuer, such as negative news releases and rating agency downgrades with respect to the issuer of the equity security.
OTTI losses in 2015 reflect $133.9 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $133.9 million of OTTI losses, $115.6 million related to equity securities, primarily in the energy, pharmaceutical, gaming and airline sectors, and $18.3 million related to debt securities, primarily in the energy and financial service sectors. The determination that unrealized losses on equity and debt securities were other than temporary was primarily due to the fact that Alleghany lacked the intent to hold the securities for a period of time sufficient to allow for an anticipated recovery and, to a lesser extent, based on the duration of the decline in the fair value of equity securities relative to their costs.
After adjusting the cost basis of securities for the recognition of OTTI losses, the remaining gross unrealized investment losses for debt and equity securities as of December 31, 2016 were deemed to be temporary, based on, among other factors: (i) the duration of time and the relative magnitude to which the fair value of these investments had been below cost were not indicative of an OTTI loss; (ii) the absence of compelling evidence that would cause Alleghany to call into question the financial condition or near-term business prospects of the issuer of the security; and (iii) Alleghany’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery.
Investments with fair values of approximately $1.7 billion as of December 31, 2016, the substantial majority of which were debt securities and equity securities, were deposited with governmental authorities as required by law.
In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited (“Pillar Holdings”), a Bermuda-based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities. Additionally, TransRe invested $175.0 million and AIHL invested $25.0 million in limited partnership funds managed by Pillar Holdings (the “Funds”). The objective of the Funds is to create portfolios with attractive risk-reward characteristics and low correlation with other asset classes, using the extensive reinsurance and capital market experience of the principals of Pillar Holdings. Alleghany has concluded that both Pillar Holdings and the Funds (collectively, the “Pillar Investments”) represent variable interest entities and that Alleghany is not the primary beneficiary, as it does not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, the Pillar Investments are not consolidated and are accounted for under the equity method of accounting. Alleghany’s potential maximum loss in the Pillar Investments is limited to its cumulative net investment. As of December 31, 2016, Alleghany’s carrying value in the Pillar Investments, as determined under the equity method of accounting, was $233.7 million, which is net of returns of capital received from the Pillar Investments.
As of December 31, 2016, the carrying value of Alleghany’s commercial loan portfolio was $594.9 million, representing the unpaid principal balance on the loans. As of December 31, 2016, there was no allowance for loan losses. The commercial loan portfolio consists primarily of first mortgages on commercial properties in major metropolitan areas in the U.S. The loans earn interest at fixed- and floating-rates, mature in two to ten years and the principal amounts of the loans were no more than approximately two-thirds of the property’s appraised value at the time the loan was made.
Amounts recoverable from reinsurers are recognized in a manner consistent with the claims liabilities associated with the reinsurance placement and presented on the balance sheet as reinsurance recoverables. Such balances as of December 31, 2016 and 2015 consisted of the following:
The following table presents information regarding concentration of Alleghany’s reinsurance recoverables and the ratings profile of its reinsurers as of December 31, 2016:
(3) In December 2016, Fairfax Financial Holdings Ltd announced its agreement to acquire Allied World Assurance Company Holdings, AG.
Alleghany had no allowance for uncollectible reinsurance as of December 31, 2016 and 2015.
In addition, RSUI’s property per risk reinsurance program runs on an annual basis from May 1 to the following April 30 and thus expired on April 30, 2016. On May 1, 2016, the property per risk program was renewed and the new program will expire on April 30, 2017. For the 2016 to 2017 period, RSUI’s property per risk reinsurance program provides coverage for $90.0 million of losses, subject to a 10.0 percent co-participation by RSUI, in excess of a $10.0 million net retention per risk after application of surplus share treaties and facultative reinsurance.
primarily for adverse development on certain net loss and allocated LAE in excess of its carried reserves at June 30, 2015. AIHL Re’s commitments are intended to cover the statutory collateral requirements at CapSpecialty, if and when necessary, and AIHL Re’s obligations are subject to an aggregate limit of $50.0 million. In connection with such intercompany reinsurance agreement, Alleghany and AIHL Re entered into a contract whereby Alleghany will guarantee the recoverable balances owed to CapSpecialty from AIHL Re up to $50.0 million. The above agreements had no impact on Alleghany’s consolidated results of operations and financial condition.
Gross loss and LAE reserves as of December 31, 2016 increased from December 31, 2015, reflecting increases in the reinsurance and insurance segments. The increase in gross loss and LAE reserves at the reinsurance segment primarily reflects the impact of higher net premiums earned and higher catastrophe losses, partially offset by favorable prior accident year loss reserve development. The increase in gross loss and LAE reserves at the insurance segment primarily reflects higher current accident year losses and higher catastrophe losses, partially offset by favorable prior accident year loss reserve development.
(1) Reflects favorable prior accident year loss reserve development from several catastrophes that occurred in the 2010 through 2015 accident years.
(6) Reflects favorable prior accident year loss reserve development primarily related to the 2012 accident year and, to a lesser extent, the 2011 accident year.
(11) Generally reflects favorable prior accident year loss reserve development in a variety of casualty & other lines of business primarily from the 2003 through 2007 and 2010 through 2011 accident years, partially offset by unfavorable prior accident year loss reserve development from the 2013 accident year and the 2002 and prior accident years.
(12) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business related to the 2006 through 2012 accident years.
(13) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business related to the 2006 through 2011 accident years, partially offset by unfavorable prior accident year loss reserve development in the directors’ and officers’ liability lines of business related to the 2011 through 2014 accident years.
(16) Primarily reflects favorable prior accident year development of ($4.1) million from Super Storm Sandy in 2012, net of reinsurance, and favorable prior accident year loss reserve development related to unallocated LAE reserves.
(20) Primarily reflects favorable prior accident year loss reserve development related to 2012 and prior accident years.
(21) Primarily reflects unfavorable prior accident year loss reserve development related to 2009 and prior accident years.
The following is supplemental information about incurred and paid loss and LAE development, net of reinsurance. Information is also included for the portion of unpaid loss and LAE, net of reinsurance recoverables, that relate to IBNR and, for the insurance segment, the cumulative number of reported insurance claims.
On October 15, 2013, Alleghany entered into a four-year credit agreement (the “Credit Agreement”) which provides for an unsecured credit facility in an aggregate principal amount of up to $200.0 million. The Credit Agreement is scheduled to terminate on October 15, 2017, unless terminated at an earlier date. Borrowings under the Credit Agreement will be available for working capital and general corporate purposes.
In the fourth quarter of 2015, Alleghany borrowed and repaid $60.0 million under the Credit Agreement. As of December 31, 2016, there were no outstanding borrowings under the Credit Agreement.
On December 14, 2005, TransRe completed a public offering of $750.0 million aggregate principal amount of its 2015 Senior Notes. Prior to the merger with TransRe, a portion of the 2015 Senior Notes was repurchased by TransRe. On October 15, 2014, TransRe redeemed $300.0 million aggregate principal amount of the 2015 Senior Notes for $324.4 million, consisting of the $300.0 million aggregate principal amount redeemed, $18.6 million of redemption premium and $5.8 million of accrued and unpaid interest to the date of redemption. Of the $324.4 million redemption amount, $297.3 million was funded by a capital contribution from Alleghany primarily using the $294.3 million of net proceeds from Alleghany’s issuance of the 2044 Senior Notes. As a result of this early extinguishment of debt, TransRe recorded a realized loss, before tax, of $9.4 million in 2014. On December 14, 2015, the remaining $367.0 million outstanding aggregate principal amount of TransRe’s 2015 Senior Notes matured and was repaid.
Income before income taxes from domestic operations was $407.7 million, $376.7 million and $633.8 million in 2016, 2015 and 2014, respectfully. Income before income taxes from foreign operations was $240.1 million, $380.7 million and $298.1 million in 2016, 2015 and 2014, respectively. Foreign tax expense was primarily attributable to the United Kingdom (the “U.K.”).
The increase in the effective tax rate in 2016 from 2015 primarily reflects larger prior period income tax expense adjustments, higher state income taxes and lower tax-exempt interest income arising from municipal bond securities. Prior period income tax expense adjustments for 2016 include $16.1 million of out-of-period reductions to current and deferred TransRe tax assets recorded in 2016 that relate primarily to periods prior to the merger with TransRe in 2012.
The slight decrease in the effective tax rate in 2015 compared with 2014 primarily reflects lower taxable income in 2015, partially offset by lower interest income arising from municipal bond securities.
A valuation allowance is provided against deferred tax assets when, in the opinion of management, it is more likely than not that a portion of the deferred tax asset will not be realized. As of December 31, 2016 and 2015, Alleghany recognized $25.2 million and $17.9 million, respectively, of deferred tax assets for certain state net operating and capital loss carryovers, and a valuation allowance of $25.2 million and $17.9 million, respectively, has been established against these deferred tax assets as Alleghany does not currently anticipate it will generate sufficient income in these states to absorb such loss carryovers.
Alleghany’s income tax returns are currently under examination by the Internal Revenue Service for the 2012, 2013 and 2014 tax years. TransRe’s income tax returns, which all relate to periods prior to the merger with Alleghany, are currently under examination by the Internal Revenue Service. The following table lists the tax years of Alleghany and TransRe tax returns that remain subject to examination by major tax jurisdictions as of December 31, 2016.
Alleghany believes that, as of December 31, 2016, it had no material uncertain tax positions. Interest and penalties relating to unrecognized tax expenses (benefits) are recognized in income tax expense, when applicable. There were no material liabilities for interest or penalties accrued as of December 31, 2016.
The following table presents a reconciliation of the changes during 2016 and 2015 in accumulated other comprehensive income attributable to Alleghany stockholders:
(1) For 2016, excludes a ($98.8) million impairment charge from a write-down of certain SORC assets and the Jazwares Remeasurement Gain of $13.2 million. For 2015, excludes a ($25.8) million realized capital loss related to an impairment charge related to a write-off of Alleghany’s investment in ORX.
As of December 31, 2016, approximately $6.6 billion of Alleghany’s total equity of $7.9 billion was unavailable for dividends or advances to Alleghany from its subsidiaries. The remaining $1.3 billion was available for dividends or advances to Alleghany from its subsidiaries, or was retained at the Alleghany parent company-level and, as such, was available to pay dividends to Alleghany’s stockholders as of December 31, 2016.
68,429, 77,441 and 72,528 contingently issuable shares were potentially available during 2016, 2015 and 2014, respectively, but were not included in the diluted earnings per share computations because the impact was anti-dilutive to the earnings per share calculation.
Alleghany and its subsidiaries lease certain facilities, furniture and equipment under long-term lease agreements. In addition, certain land, office space and equipment are leased under non-cancelable operating leases that expire at various dates through 2031. Rent expense was $37.5 million, $34.0 million and $33.8 million in 2016, 2015 and 2014, respectively. The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2016 were as follows:
Loss and LAE include amounts for risks relating to asbestos-related illness and environmental impairment. As of December 31, 2016 and 2015, such gross and net reserves were as follows:
As of December 31, 2016, Alleghany had holdings in energy sector businesses of $871.1 million, comprised of $313.3 million of debt securities, $408.6 million of equity securities and $149.2 million of our equity attributable to SORC.
The reinsurance segment consists of property and casualty reinsurance operations conducted by TransRe’s reinsurance operating subsidiaries and is further reported through two major product lines - property and casualty & other. TransRe provides property and casualty reinsurance to insurers and reinsurers through brokers and on a direct basis to ceding companies. TransRe also writes a modest amount of insurance business, which is included in the reinsurance segment. Over one-third of the premiums earned by TransRe’s operations are generated by offices located in Canada, Europe, Asia, Australia, Africa and those serving Latin America and the Caribbean. Although the majority of the premiums earned by these offices typically relate to the regions where they are located, a significant portion may be derived from other regions of the world, including the U.S. In addition, although a significant portion of the assets and liabilities of these foreign offices generally relate to the countries where ceding companies and reinsurers are located, most investments are located in the country of domicile of these offices.
The components of other activities are Alleghany Capital and corporate activities. Alleghany Capital consists of manufacturing and service operations, oil and gas operations and corporate operations and investments at the Alleghany Capital level. Manufacturing and service operations are conducted through Bourn & Koch, Kentucky Trailer, IPS and Jazwares. Oil and gas operations are conducted through SORC, and also included Alleghany Capital’s investment in ORX until it was sold on December 23, 2016. ORX was accounted for under the equity method of accounting.
(3) Includes amortization associated with deferred acquisition costs of $1,253.2 million, $1,024.5 million and $1,042.0 million for the years ended December 31, 2016, 2015 and 2014, respectively.
Foreign gross premiums written in 2016, 2015 and 2014 were approximately $1.5 billion, $1.6 billion and $1.7 billion, respectively.
Foreign net premiums earned in 2016, 2015 and 2014 were approximately $1.4 billion, $1.4 billion and $1.5 billion, respectively. The foreign country in which Alleghany generates the largest amount of premium revenues is the U.K. Net premiums earned by operations in the U.K. in 2016, 2015 and 2014 were $622.3 million, $640.4 million and $654.8 million, respectively.
Significant portions of the reinsurance segment’s gross premiums written are produced by a limited number of brokers. Gross premiums written produced by the reinsurance segment’s three largest brokers were approximately 25 percent, 20 percent, and 16 percent in 2016, 26 percent, 20 percent and 10 percent in 2015 and approximately 29 percent, 22 percent and 11 percent in 2014.
A large whole account quota share treaty entered into in the fourth quarter of 2015 accounted for approximately 20 percent in 2016 and 6 percent in 2015 of gross premiums written in the reinsurance segment.
The annual grant to each non-employee director consists of either restricted shares or restricted stock units, at the director’s election. Awards granted to non-employee directors were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2016.
In February 2012, Alleghany adopted the 2012 Long-Term Incentive Plan (the “2012 LTIP”), which was approved by Alleghany stockholders in April 2012. Awards under the 2012 LTIP may include, but are not limited to, cash and/or shares of Common Stock, rights to receive cash and/or shares of Common Stock and options to purchase shares of Common Stock, including options intended to qualify as incentive stock options under the Internal Revenue Code, and options not intended to so qualify. Under the 2012 LTIP, the following types of awards were outstanding as of December 31, 2016:
RSUI has a Restricted Stock Unit Plan (the “RSUI Plan”) for the purpose of providing equity-like incentives to key employees of RSUI. Under the RSUI Plan, restricted stock units (“units”) are issued. Additional units, defined as the “Deferred Equity Pool,”
were issued in 2016, 2015 and 2014 and may be created in the future if certain financial performance measures are met. Units may only be settled in cash. The fair value of each unit is calculated as stockholder’s equity of RSUI, adjusted for certain capital transactions and accumulated compensation expense recognized under the RSUI Plan, divided by the sum of RSUI common stock outstanding and the original units available under the RSUI Plan. The units vest on the fourth anniversary of the date of grant and contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2016, 2015 and 2014, RSUI recorded $25.4 million, $22.7 million and $28.2 million, respectively, in compensation expense related to the RSUI Plan. During the same periods, a deferred tax benefit of $8.9 million, $7.9 million and $9.9 million, respectively, related to the compensation expense was recorded.
Alleghany has an unfunded, noncontributory defined benefit pension plan for parent company-level executives, which was frozen as of December 31, 2013, and a funded, noncontributory defined benefit pension plan for parent company-level employees. The projected benefit obligations of the defined benefit pension plans as of December 31, 2016 and 2015 was $30.2 million and $28.2 million, respectively, and the related fair value of plan assets was $2.4 million and $2.5 million, respectively.
TransRe has an unfunded, noncontributory defined benefit plan and a funded noncontributory defined benefit plan for certain of its employees in the U.S. Benefits under TransRe’s defined benefit plans were frozen as of December 31, 2009. As of December 31, 2016 and 2015, the projected benefit obligation was $65.4 million and $63.0 million, respectively, and the related fair value of plan assets was $48.7 million and $46.7 million, respectively.