The principal executive offices of Alleghany, ACC and Roundwood are located in leased office space in New York, New York. TransRe leases office space in almost all of its locations around the world. RSUI leases office space in Atlanta, Georgia for its headquarters and office space in Sherman Oaks, California. Capitol leases office space in Middleton, Wisconsin for its and Platte River’s headquarters. PCC leases office space in Agoura Hills, California. BKI and Kentucky Trailer own their principal office and manufacturing facilities, which are located in Rockford, Illinois and Louisville, Kentucky, respectively. Stranded Oil leases office space in Austin, Texas. Alleghany Properties leases office space in Sacramento, California. Management considers its facilities suitable and adequate for the current level of operations.
We are a Delaware corporation which owns and manages operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance. Prior to the TransRe Acquisition Date, we were primarily engaged, through our wholly-owned subsidiary AIHL and its subsidiaries, in the property and casualty insurance business. AIHL’s insurance operations are principally conducted by its subsidiaries RSUI, Capitol and PCC. In addition, AIHL Re has been an indirect, wholly-owned subsidiary of Alleghany since its formation in 2006. AIHL Re is a captive reinsurance company which provides reinsurance to our insurance operating subsidiaries and affiliates. On the TransRe Acquisition Date, we consummated the merger with TransRe. As a result of the merger, TransRe became one of our wholly-owned subsidiaries. Our reinsurance operations began upon consummation of the merger. See Note 2 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 merger. Our public equity investments, including those held by TransRe’s and AIHL’s operating subsidiaries, are managed primarily by our indirect, wholly-owned subsidiary, Roundwood.
Although our primary sources of revenues and earnings are our reinsurance and insurance operations and investments, we also conduct other activities. We manage, source, execute and monitor our private capital investments primarily through our wholly-owned subsidiary, ACC. Our private capital investments include: (i) Stranded Oil Resources, an exploration and production company focused on enhanced oil recovery, headquartered in Austin, Texas; (ii) BKI, a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois; (iii) Kentucky Trailer, a manufacturer of custom trailers and truck bodies for the moving and storage industry and other markets, headquartered in Louisville, Kentucky; and (iv) an approximately 39 percent equity interest in ORX, a regional oil and gas exploration and production company.
We owned a minority stake in Homesite, a national, full-service, mono-line provider of homeowners insurance, until its sale to American Family Insurance Company, a Wisconsin-based mutual insurance company, on December 31, 2013.
As of December 31, 2013, we had total assets of $23.4 billion and total stockholders’ equity attributable to Alleghany stockholders of $6.9 billion. As of December 31, 2013, we had consolidated total investments of approximately $19.0 billion, of which $14.8 billion was invested in debt securities, $2.2 billion was invested in equity securities, $1.3 billion was invested in short-term investments, and $0.7 billion was invested in other invested assets.
Our segments are reported in a manner consistent with the way management evaluates the businesses. As such, we classify our business into two reportable segments, reinsurance and insurance. Reinsurance and insurance underwriting activities are evaluated separately from investment and corporate activities. The primary components of “corporate activities” are Alleghany Properties, Stranded Oil, our investments in Homesite (prior to its sale on December 31, 2013) and ORX and other activities at the parent level. In addition, beginning April 26, 2012 and August 30, 2013, corporate activities includes the operating results of BKI and Kentucky Trailer, respectively. See below and 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 an analysis of our underwriting results by segment and corporate activities, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Consolidated Results of Operations.”
As part of their overall risk and capacity management strategy, our reinsurance and insurance subsidiaries take certain measures to mitigate the impact of catastrophe events through various means including considering catastrophe risks in their underwriting and pricing decisions, purchasing reinsurance, monitoring and modeling accumulated exposures and managing exposure in key geographic zones and product lines that are prone to catastrophic events. The reinsurance programs purchased by our reinsurance and insurance subsidiaries are generally subject to annual renewal. Market conditions beyond the control of our reinsurance and insurance subsidiaries determine the availability and cost of the reinsurance protection they purchase, which may affect the level of business written and thus their profitability.
connection with the merger, and due diligence, legal, investment banking and other merger-related costs, or “Transaction Costs.” In addition, beginning April 26, 2012 and August 30, 2013, corporate activities includes the operating results of BKI and Kentucky Trailer, respectively. Corporate activities also includes interest expense associated with the senior notes issued by Alleghany, whereas interest expense associated with the senior notes issued by TransRe is included in “Total Segments.” Information related to the merger can be found in Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K.
Our results for 2013 compared with 2012, and 2012 compared with 2011, reflect impacts that arose from the merger. These impacts primarily relate to the gain on bargain purchase of $494.9 million in 2012, Transaction Costs (a component of corporate administration expense) of $33.8 million in 2012 and $19.3 million in 2011, and the write-off of deferred acquisition costs of TransRe as of the TransRe Acquisition Date, as well as the establishment of an intangible asset roughly approximating the amount of deferred acquisition costs. This intangible asset was amortized over an approximate one year period, similar to how deferred acquisition costs are amortized, but is shown as part of amortization of intangible assets as opposed to part of commissions, brokerage and other underwriting expenses. This amortization was largely completed as of March 6, 2013, the one year anniversary of the TransRe Acquisition Date. In addition, as the merger closed on March 6, 2012, comparative balances for 2013 reflect activity for the entire year while balances for 2012 reflect activity at TransRe only for the 300 day period from the TransRe Acquisition Date to December 31, 2012. Information related to the merger can be found in Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K.
Our earnings before income taxes in 2013 increased from 2012, primarily reflecting improved underwriting results, higher net investment income and higher realized capital gains, partially offset by the absence of merger impacts, which were significant to the 2012 results. Improved underwriting results are due primarily to lower catastrophe losses in 2013 and higher net favorable development from prior accident years on loss and LAE reserves in 2013. As described above, the decrease in catastrophe losses in 2013 from 2012 reflects the fact that 2012 includes significant losses from Super Storm Sandy. Higher net favorable development from prior accident years on loss and LAE reserves in 2013 reflects favorable development from reinsurance loss and LAE reserves, partially offset by net unfavorable development from insurance loss and LAE reserves in 2013. Aside from the impact of the merger, the increase in net investment income reflects higher income from other invested assets, as well as higher interest and dividend income. Net realized capital gains in 2013 include a $46.8 million gain on the sale of Homesite on December 31, 2013. As described above, the impacts of the merger in 2012 included the gain on bargain purchase partially offset by Transaction Costs and the net impact from the inclusion of TransRe’s results for only a 300 day period.
The effective tax rate was 26.4 percent for 2013, 2.4 percent for 2012 and 24.9 percent for 2011. The higher effective tax rate in 2013 compared with 2012 primarily reflects the absence of a gain on bargain purchase, which had a significant impact in 2012. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes. The impact of the gain on bargain purchase on the effective tax rate in 2012 was partially offset by the impact of certain non-deductible Transaction Costs in 2012, which resulted in losses before income taxes without a corresponding decrease in income taxes. Similarly, the lower effective tax rate in 2012 compared with 2011 primarily reflects the impact of the non-taxable gain on bargain purchase and, to a lesser extent, the impact of higher tax-exempt interest income generated by TransRe from the TransRe Acquisition Date through December 31, 2012, partially offset by the impact of certain non-deductible Transaction Costs. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes, whereas certain non-deductible Transaction Costs resulted in losses before income taxes without a corresponding decrease in income taxes.
The results of our total reinsurance and insurance segments for 2013 compared with 2012, and 2012 compared with 2011, reflect impacts that arose from the merger. These impacts primarily relate to the write-off of deferred acquisition costs of TransRe as of the TransRe Acquisition Date, as well as the establishment of an intangible asset roughly approximating the amount of deferred acquisition costs. This intangible asset was amortized over an approximate one year period, similar to how deferred acquisition costs are amortized, but is shown as part of amortization of intangible assets as opposed to part of commissions, brokerage and other underwriting expenses. This amortization was largely completed as of March 6, 2013, the one year anniversary of the TransRe Acquisition Date. In addition, as the merger closed on March 6, 2012, comparative balances for 2013 reflect activity for the entire year while balances for 2012 reflect activity at TransRe only for the 300 day period from the TransRe Acquisition Date to December 31, 2012.
The earnings before income taxes of our total reinsurance and insurance segments in 2013 increased from 2012, primarily reflecting improved underwriting results and higher net investment income and the absence of
merger impacts, which were significant to the 2012 results, partially offset by lower other income. Improved underwriting results are due primarily to lower catastrophe losses in 2013 and higher net favorable development from prior accident years on loss and LAE reserves in 2013. As described above, the decrease in catastrophe losses in 2013 from 2012 reflects the fact that we incurred significant losses from Super Storm Sandy in 2012. Higher net favorable development from prior accident years on loss and LAE reserves in 2013 reflects favorable development from reinsurance loss and LAE reserves, partially offset by net unfavorable development from insurance loss and LAE reserves in 2013. Aside from the impact of the merger, the increase in net investment income reflects higher income from other invested assets, as well as higher interest and dividend income. As described above, the impacts of the merger in 2012 included the net impact from the inclusion of TransRe’s results for only a 300 day period. Other income in 2012 includes a $23.5 million gain from the settlement of a dispute between TransRe and American International Group, Inc., or “AIG.”
(1) Primarily consists of the following assumed reinsurance lines of business: D&O liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; surety; and credit.
The decrease in net losses and LAE primarily reflects a decrease in catastrophe losses and an increase in favorable prior accident year development on loss reserves, partially offset by the inclusion of operations from TransRe for the entire year for 2013, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012. Net loss and LAE includes catastrophe losses, net of reinsurance, of $92.1 million in 2013, compared with $252.2 million of catastrophe losses in 2012, all of which related to Super Storm Sandy. Catastrophe losses in 2013 primarily reflect net losses from flooding in Germany in May 2013, flooding in Central Europe and Canada in June 2013, hurricanes in Mexico in September 2013 and hailstorms in Germany and Canada in July 2013.
Net loss and LAE for 2013 reflect $184.7 million of favorable prior accident year development on loss reserves, compared with $56.6 million of favorable development in 2012. For 2013, the $184.7 million favorable development includes $73.7 million related to Super Storm Sandy. The remaining $111.0 million of favorable development related primarily to catastrophe events prior to 2012, including flooding that took place in Thailand and the Tohoku earthquake in Japan, both of which occurred in 2011, and to prior accident year non-catastrophe reserves from recent accident years. The $184.7 million favorable development in 2013 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The $184.7 million favorable development did not impact the assumptions used in estimating TransRe’s loss and LAE liabilities for business earned in 2013. For 2012, the $56.6 million favorable development related to favorable loss development from prior accident years on loss and LAE reserves acquired on the TransRe Acquisition Date.
The increase in commissions, brokerage and other underwriting expenses primarily reflects the diminished favorable impact arising from the acquisition method of accounting, as further explained below.
The increase in underwriting profit in 2013 from 2012 primarily reflects an increase in net premiums earned and a decrease in net loss and LAE, partially offset by an increase in commissions, brokerage and other underwriting expenses, all as discussed above.
Reinsurance Segment - Casualty & Other. The increases in gross premiums written, net premiums earned, and commissions, brokerage and other underwriting expenses in 2013 from 2012 primarily reflect the impact from the merger, specifically related to the inclusion of operations from TransRe for the entire year for 2013, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012.
Absent the impact from the merger, gross premiums written and net premiums earned would have decreased in 2013 from 2012. The decrease in gross premiums written reflects an increasingly competitive reinsurance market and a decreasing amount of risk premium being ceded by insurers, as well as decisions made by TransRe in recent years to non-renew or reduce participation on certain potentially less profitable treaties and shift certain business from proportional to potentially more profitable non-proportional exposure. The decrease in net premiums earned primarily reflects a decrease in gross premiums written in recent quarters.
The underwriting loss in 2013, compared with an underwriting profit in 2012, primarily reflects an increase in net loss and LAE and commissions, brokerage and other underwriting expenses, partially offset by an increase in net premiums earned, all as discussed above.
For both the property and the casualty & other lines of business, the expense ratio for 2012 was favorably impacted as a result of applying the acquisition method of accounting for the merger because deferred acquisition costs were written off at the TransRe Acquisition Date. As of March 6, 2013, the application of the acquisition method of accounting no longer had a significant impact on the expense ratio. Consequently, the impact on the expense ratio for 2013 was not significant. Excluding the impact of the application of the acquisition method of accounting, the expense ratio for the reinsurance segment was estimated to be approximately 29 percent for 2012.
The insurance segment is comprised of AIHL’s RSUI, Capitol and PCC operating subsidiaries. RSUI also writes a modest amount of assumed reinsurance business, which is included in the insurance segment. For a more detailed description of our insurance segment, see Part I, Item 1, “Business-Segment Information-Insurance Segment” of this Form 10-K.
(3) The loss ratio is derived by dividing the amount of net loss and LAE incurred by net premiums earned, all as determined in accordance with GAAP.
The decrease in net loss and LAE in 2013 from 2012 primarily reflects lower catastrophe losses, net of reinsurance, partially offset by the impact of higher net premiums earned and less favorable prior accident year development on casualty loss reserves. The increase in net loss and LAE in 2012 from 2011 primarily reflects higher catastrophe losses and the impact of an increase in net premiums earned, and, to a lesser extent, less favorable prior accident year development on casualty loss reserves, partially offset by unfavorable prior accident year development on property loss reserves in 2012.
Net loss and LAE for 2013 reflect $8.0 million of unfavorable prior accident year development on property loss reserves, compared with $17.0 million of unfavorable prior accident year development in 2012 and $3.3 million of favorable prior accident year development in 2011. For 2013, the $8.0 million includes $8.5 million of unfavorable development from Hurricane Katrina in 2005, which arose from a significant claim that settled for a larger amount than previously estimated due to an adverse court ruling, partially offset by net favorable development with respect to other property reserves. For 2012, the $17.0 million includes $9.7 million of unfavorable development from Hurricane Ike in 2008.
The increase in commissions, brokerage and other underwriting expenses in 2013 compared with 2012, and in 2012 compared with 2011, is due primarily to the impact of higher net premiums earned.
The increase in RSUI’s 2013 underwriting profit compared with 2012 primarily reflects an increase in net premiums earned and a decrease in net loss and LAE, partially offset by an increase in commissions, brokerage and other underwriting expenses, all as discussed above. The decrease in RSUI’s underwriting profit in 2012 from 2011 primarily reflects an increase in loss and LAE, partially offset by an increase in net premiums earned, all as discussed above.
RSUI reinsures its property lines of business through a program consisting of surplus share treaties, facultative placements, per risk, and catastrophe excess-of-loss treaties. RSUI’s catastrophe reinsurance program (which covers catastrophe risks including, among others, windstorms and earthquakes) and per risk reinsurance program run on an annual basis from May 1 to the following April 30 and thus will expire on April 30, 2014.
Additional information regarding RSUI’s use of reinsurance for its property line of business and risks related to reinsurance recoverables can be found on pages 32 and 33 and pages 44 and 45 of this Form 10-K.
With respect to the $25.8 million net unfavorable prior accident year development on loss reserves in 2013, actual losses from prior accident years for such lines of business, which include both loss payments and case reserves, were higher than expected through December 31, 2013. The amount of higher actual losses than expected, expressed as a percentage of carried loss and LAE reserves at the beginning of the year, was 10.7 percent. Such reduction did not impact the assumptions used in estimating Capitol’s loss and LAE.
PCC. Commencing August 1, 2009, PCC ceased soliciting new or renewal business on a direct basis due to its determination that it was unable to write business at rates it deemed adequate due to the state of the California workers’ compensation market. After taking steps to transition to being a brokerage carrier, PCC began writing a modest amount of new business through brokers during 2011. This business increased in 2012 and 2013 as market conditions improved. PCC reported an underwriting loss of $33.2 million in 2013, $31.2 million in 2012 and $51.6 million in 2011. The underwriting losses are primarily due to PCC’s ongoing expenses relative to comparatively low premiums earned and unfavorable prior accident year development on loss reserves.
Loss and LAE for 2013 include $13.2 million of unfavorable prior accident year development on prior accident year workers’ compensation loss reserves compared with a $5.6 million unfavorable development in 2012 and a $28.7 unfavorable prior accident year development in 2011. For 2013 and 2012, the unfavorable development reflects unfavorable workers’ compensation loss emergence compared with loss emergence patterns assumed in earlier periods primarily for the 2005 through 2009 accident years, and to a lesser extent, an increase in unallocated LAE reserves and a decrease in ceded losses. For 2011, the $28.7 million of unfavorable development specifically related to an unanticipated increase in medical claims emergence, the absence of anticipated favorable indemnity claims emergence, and an increase in LAE reserves arising in part from an increased use of outside counsel to assist in the settlement process, as well as a decrease in ceded loss and LAE reserves based on a review of reinsurance coverage estimates.
Net Investment Income. The increase in net investment income for the reinsurance and insurance segments in 2013 from 2012 is due primarily to the inclusion of operations from TransRe for the entire year for 2013, compared with only 300 days subsequent to the TransRe Acquisition Date for 2012. Aside from the impact of the merger, the increase in net investment income reflects higher income from other invested assets, as well as higher interest and dividend income.
The increase in net investment income for the reinsurance and insurance segments in 2012 from 2011 is due principally to the impact of including TransRe’s results commencing on the TransRe Acquisition Date, partially offset by a decrease in interest income in the insurance segment due to lower prevailing market yields.
(1) Average of amortized cost of debt securities portfolio at beginning and end of period. With respect to the debt securities owned by TransRe, the beginning of the period is the TransRe Acquisition Date.
OTTI losses for 2011 reflect $3.6 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $3.6 million, $3.1 million related to equity security holdings, primarily in the materials and financial services sectors, and $0.5 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity of the declines in fair value of such securities relative to their cost as of the balance sheet date.
Corporate activities results include the results of BKI beginning April 26, 2012, and Kentucky Trailer beginning August 30, 2013. As a consequence, other income and other operating expenses have increased in 2013 compared with 2012, and in 2012 compared with 2011.
Net investment income for corporate activities includes our equity share of results in Homesite and ORX, as follows:
The higher interest, dividends and other - net in 2013 compared with 2012 primarily reflects higher income from other invested assets.
The lower interest, dividends and other - net in 2012 compared with 2011 primarily reflects significantly lower dividends, partially offset by higher interest income. Lower dividends are due primarily to the sale in January 2012 of shares of Exxon Mobil Corporation common stock held at the corporate-level. Higher interest income reflects the investment of proceeds arising from the issuance of Alleghany Senior Notes (as defined on page 84 of this Form 10-K) on June 26, 2012.
(3) Primarily consists of commercial multi-peril, surety and loss and LAE reserves for terminated lines of business and loss reserves acquired in connection with prior acquisitions for which the sellers provided loss reserve guarantees.
In the normal course of their business, our reinsurance and insurance subsidiaries purchase reinsurance from highly-rated third party reinsurers in order to minimize loss from large losses or catastrophic events. The reinsurance purchased by our reinsurance and insurance subsidiaries does not relieve them from their obligations to their policyholders and cedants, and therefore, the financial strength of their reinsurers is important. As of December 31, 2013, our reinsurance and insurance subsidiaries had total reinsurance recoverables of $1,363.7 million, consisting of $1,302.1 million of ceded outstanding loss and LAE and $61.6 million of recoverables on paid losses. See Part I, Item 1, “Business - Reinsurance Protection” of this Form 10-K for additional information on the reinsurance purchased by our reinsurance and insurance subsidiaries.
Information regarding concentration of our reinsurance recoverables and the ratings profile of our reinsurers as of December 31, 2013 is as follows:
We had no allowance for uncollectible reinsurance as of December 31, 2013.
For short-tail lines, loss reserves consist primarily of reserves for reported claims. The process of recording quarterly and annual liabilities for unpaid loss and LAE for short-tail lines is primarily focused on maintaining an appropriate reserve level for reported claims and IBNR. Specifically, we assess the reserve adequacy of IBNR in light of such factors as the current levels of reserves for reported claims and expectations with respect to reporting lags, catastrophe events, historical data, legal developments, and economic conditions, including the effects of inflation.
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
We believe that the reserves for unpaid loss and LAE established by our reinsurance and insurance subsidiaries are adequate as of December 31, 2013; 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.
Our loss reserve review processes use actuarial methods that vary by operating subsidiary and line of business and produce point estimates for each class of business. The actuarial methods used include the following methods:
Prior Year Development. Our reinsurance and insurance subsidiaries continually evaluate the potential for changes, both positive and negative, in their estimates of their 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 positive or negative 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 positive and negative, 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 2013, 2012 and 2011 based on current information that differed from previous assumptions made at the time such loss and LAE reserves were previously estimated. These reserve (decreases) increases to prior year net reserves are summarized as follows:
Capitol. For 2013, the $25.8 million net unfavorable development includes $19.4 million of unfavorable development related to the Terminated Program in the 2010 and 2009 accident years, and $10.4 million of unfavorable development from workers’ compensation and certain other casualty lines of business, partially offset by $4.0 million of favorable development from Capitol’s asbestos-related illness and environmental impairment reserves. The $10.4 million unfavorable development in 2013 from workers’ compensation and certain other casualty lines of business related primarily to unfavorable loss emergence on a few individual claims, partially offset by favorable development on surety lines of business. For 2012, the $13.2 million net unfavorable development includes $22.2 million unfavorable development related to the Terminated Program in the 2010 and 2009 accident years, partially offset by net favorable development in certain of Capitol’s casualty and surety lines of business. For 2011, the $5.0 million net unfavorable development includes $14.6 million of unfavorable development related to the Terminated Program, partially offset by net favorable development in certain of Capitol’s casualty lines of business. The unfavorable development related to the Terminated Program in 2013, 2012 and 2011 reflect continued unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
Reinsurance. Our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines, improve risk-adjusted portfolio returns and enable them to increase gross premium writings and risk capacity for other business without requiring additional capital. Although our reinsurance and insurance subsidiaries purchase reinsurance from highly-rated third party reinsurers, if the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such amounts not paid by their reinsurers. Recoverables recorded with respect to claims ceded to reinsurers under reinsurance contracts are predicated in large part on the estimates for unpaid losses and, therefore, are also subject to a significant degree of uncertainty. In addition to the factors cited above, reinsurance recoverables may prove uncollectible if a reinsurer is unable or unwilling to perform under a contract. Reinsurance purchased by our reinsurance and insurance subsidiaries does not relieve them of their obligations to their own policyholders or cedants. Additional information regarding the use of, and risks related to, the use of reinsurance by our reinsurance and insurance subsidiaries can be found on pages 32 and 33 and pages 44 and 45 of this Form 10-K. Also see Note 1(f) and Note 5 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 on our reinsurance recoverables.
We then evaluate those equity securities where the unrealized loss is 20 percent or more of cost as of the balance sheet date or which 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 company, such as negative news releases and rating agency downgrades with respect to the issuer of the investment.
If we intend to sell or it is more likely than not that we will sell a debt security before recovery of its amortized cost basis, the total amount of the unrealized loss position is recognized as an OTTI loss in earnings. To the extent that a debt security that is in an unrealized loss position is not impaired based on the preceding, we will consider a debt security to be impaired when we believe it to be probable that we will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, we develop a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate we will not recover the full amount of its amortized cost basis in the debt security, we record an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the debt security. If applicable, the difference between the total unrealized loss position on the debt security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.
intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and intangible assets that have an indefinite useful life are not subject to amortization.
With respect to goodwill, a qualitative assessment is first made to determine whether it is necessary to perform quantitative testing. This initial assessment includes, among others, consideration of: (i) past, current and projected future earnings and equity; (ii) recent trends and market conditions; and (iii) valuation metrics involving similar companies that are publicly-traded and acquisitions of similar companies, if available. If this initial qualitative assessment indicates that the fair value of an operating subsidiary of ours may be less than its respective carrying amount, a second step is taken, involving a comparison between the estimated fair values of our operating subsidiaries with their respective carrying amounts including goodwill. Under GAAP, fair value refers to the amount for which the entire operating subsidiary may be bought or sold. The methods for estimating operating subsidiary values include asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. All of these methods involve significant estimates and assumptions. If the carrying value exceeds estimated fair value, there is an indication of potential impairment, and a third step is performed to measure the amount of impairment. The third step involves calculating an implied fair value of goodwill by measuring the excess of the estimated fair value of the operating subsidiaries over the aggregate estimated fair values of the individual assets less liabilities. If the carrying value of goodwill exceeds the implied fair value of goodwill, an impairment charge is recorded for the excess.
require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities that do not meet the level of materiality required for a determination that the accounting policy includes critical accounting estimates. On an ongoing basis, we evaluate our estimates, including those related to the value of deferred acquisition costs, incentive compensation, income taxes, pension benefits and contingencies and litigation. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our actual results may differ from these estimates under different assumptions or conditions.
On September 20, 2010, we completed a public offering of $300.0 million aggregate principal amount of our 5.625% senior notes due on September 15, 2020, or the “2020 Senior Notes.” The 2020 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest is payable semi-annually on March 15 and September 15 of each year. The terms of the 2020 Senior Notes permit redemption prior to their maturity. The indenture under which the 2020 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 2020 Senior Notes were issued at approximately 99.6 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $298.9 million, and an effective yield of approximately 5.67 percent. Approximately $2.8 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2020 Senior Notes.
Credit Agreement. On October 15, 2013, we entered into a four-year credit agreement, or the “Credit Agreement,” with certain lenders party thereto, 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 earlier terminated. Borrowings under the Credit Agreement will be available for working capital and general corporate purposes. The Credit Agreement replaced our previous three-year credit agreement, or the “Prior Credit Agreement,” which provided for a two tranche revolving credit facility in an aggregate principal amount of up to $100 million, consisting of a secured credit facility in an aggregate principal amount of up to $50.0 million and an unsecured credit facility in an aggregate principal amount of up to $50.0 million. The Prior Credit Agreement expired on September 9, 2013. There were no borrowings under the Prior Credit Agreement from its inception through its expiration.
There were no borrowings under the Credit Agreement since its inception through December 31, 2013.
Dividends from Subsidiaries. As of December 31, 2013, approximately $6.2 billion of our total equity of $6.9 billion was unavailable for dividends or advances to us from our subsidiaries. The remaining $0.7 billion was available for dividends or advances to Alleghany from its subsidiaries, or was retained at the Alleghany parent-level, and as such, was available to pay dividends to Alleghany’s stockholders as of December 31, 2013.
Common Stock Repurchases. In October 2012, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2013, 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 and the 2022 Senior Notes; and (ii) the “TransRe Senior Notes,” consisting of TransRe’s 5.75% senior notes due on December 14, 2015, and the 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.
In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited, or “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, or the “Funds,” which are managed by Pillar Holdings. 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. We have concluded that both Pillar Holdings and the Funds, which we collectively refer to as the “Pillar Investments,” represent variable interest entities and that we are not the primary beneficiary, as we do 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. Our potential maximum loss is limited to our cumulative investment. As of December 31, 2013, our carrying value in the Pillar Investments, as determined under the equity method of accounting, was $227.7 million, which is reported in other invested assets on our consolidated balance sheets.
The obligations and cash outflow of our reinsurance and insurance subsidiaries include claim settlements, commission expenses, administrative expenses, purchases of investments, and interest and principal payments on the TransRe Senior Notes. In addition to premium collections, cash inflow is obtained from interest and dividend income and maturities and sales of investments. Because cash inflow from premiums is received in advance of cash outflow required to settle claims, our reinsurance and insurance subsidiaries accumulate funds which they invest pending the need for liquidity. As the cash needs of a reinsurance or an insurance company can be unpredictable due to the uncertainty of the claims settlement process, our reinsurance and insurance subsidiaries portfolios consist primarily of debt securities and short-term investments to ensure the availability of funds and maintain a sufficient amount of liquid securities.
Investment Strategy and Holdings. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize our risk-adjusted, after-tax rate of return. Our investment decisions are guided mainly by the nature and timing of expected liability payouts, management’s forecast of cash flows and the possibility of unexpected cash demands, for example, to satisfy claims due to catastrophe losses. Our consolidated investment portfolio currently consists mainly of highly rated and liquid debt securities and equity securities listed on national securities exchanges. The overall debt securities portfolio credit quality is measured
* Consists of $56.9 million of securities rated BB / Ba, $132.5 million of securities rated B, $79.5 million of securities rated CCC, $26.7 million of securities rated CC, $5.0 million of securities rates below CC and $29.3 million of not-rated securities.
Effective duration measures a portfolio’s sensitivity to change in interest rates. In this regard, as of December 31, 2013, our debt securities portfolio had an effective duration of approximately 4.5 years compared with 3.7 years as of December 31, 2012. The increase in duration in 2013 is due primarily to the increase in market interest rates, which reduces the likelihood that RMBS will be prepaid and that municipal bonds will be called, and the purchase of long duration U.S. Treasury Strips in the fourth quarter of 2013. As of December 31, 2013, approximately $4.3 billion, or 29.0 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 modestly 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.
On a consolidated basis, our invested assets were approximately $19.0 billion as of December 31, 2013, compared with approximately $18.3 billion as of December 31, 2012. The increase in our invested assets primarily reflects the investment of positive cash flow at our reinsurance and insurance segments and net unrealized appreciation of our equity securities portfolio during 2013, partially offset by net unrealized depreciation of our debt securities portfolio during 2013 due to a general rise in interest rates.
Although we are responsible for the determination of the fair value of the financial assets and the supporting methodologies and assumptions, we employ third party valuation service providers to gather, analyze and interpret market information and derive fair values based upon relevant methodologies and assumptions for individual instruments. When those providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting a quote, which is generally non-binding, from brokers who are knowledgeable about these securities or by employing widely accepted internal valuation models.
“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. Market-based inputs include interest rates and yield curves that are observable at commonly quoted intervals and current credit rating(s) of the security. Level 2 assets generally include short-term investments and most debt securities. Our Level 2 liabilities consist of the senior notes.
We evaluate catastrophic events and assess the probability of occurrence and magnitude through the use of industry recognized models and other techniques. We supplement these models by judgmentally interpreting and adjusting when appropriate the modeled output and by periodically monitoring the exposure risks of our operations. There is no single standard methodology to project possible losses from catastrophe exposures. Further, there are no industry standard assumptions used in projecting these losses, and the form and quality of the data obtained, including data obtained from insureds and ceding companies, and used in these models are not uniformly compatible with the data requirements of all models. Therefore, the use of different methodologies and assumptions could materially change the projected losses. Finally, these modeled losses may not be comparable with estimates made by other companies.
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 catastrophic 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, 2014 for TransRe and December 1, 2013 for RSUI.
We have audited the accompanying consolidated balance sheets of Alleghany Corporation and subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2013. 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Alleghany Corporation and subsidiaries at December 31, 2013 and 2012, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alleghany Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 25, 2014 expressed an unqualified opinion thereon.
Alleghany Corporation (“Alleghany”), a Delaware corporation, owns and manages operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance. Alleghany was incorporated in 1984 under the laws of the State of Delaware and in December 1986, it succeeded to the business of its parent company, Alleghany Corporation, which was incorporated in 1929. Prior to March 6, 2012, Alleghany was primarily engaged, through its wholly-owned subsidiary Alleghany Insurance Holdings LLC (“AIHL”) and its subsidiaries, in the property and casualty insurance business. AIHL’s insurance operations are principally conducted by its subsidiaries RSUI Group, Inc. (“RSUI”), Capitol Transamerica Corporation and Platte River Insurance Company (collectively, “Capitol”), and Pacific Compensation Corporation (“PCC”). Capitol has been a subsidiary of AIHL since January 2002, RSUI has been a subsidiary of AIHL since July 2003, and PCC has been a subsidiary of AIHL since July 2007. AIHL Re LLC (“AIHL Re”) has been an indirect, wholly-owned subsidiary of Alleghany since its formation in 2006. AIHL Re is a captive reinsurance company which provides reinsurance to our insurance operating subsidiaries and affiliates. On March 6, 2012, (the “TransRe Acquisition Date”), Alleghany consummated a merger transaction (the “merger”) with Transatlantic Holdings, Inc. (“TransRe”). As a result of the merger, TransRe became one of Alleghany’s wholly-owned subsidiaries. Alleghany’s reinsurance operations began upon consummation of the merger. Alleghany’s public equity investments, including those held by TransRe’s and AIHL’s operating subsidiaries, are managed primarily by Alleghany’s indirect, wholly-owned subsidiary, Roundwood Asset Management LLC (“Roundwood”).
TransRe, through its principal wholly-owned subsidiaries, Transatlantic Reinsurance Company (“TRC”), TransRe London Ltd. (“TRL”) and TransRe Zurich Ltd. (“TRZ”), offers reinsurance capacity to reinsurance and insurance companies for property and casualty products. These products are distributed through brokers and on a direct basis in both the domestic and foreign markets. TransRe is headquartered in New York, New York with six other locations in the U.S. and has operations worldwide, including: Africa, Australia, Bermuda, Canada, four locations in Asia, three locations in Central and South America, and seven locations in the United Kingdom and Europe. TRC is licensed, accredited or authorized or can serve as a reinsurer in all 50 states and the District of Columbia in the U.S. and in Puerto Rico and Guam. TRC is also licensed in Bermuda, Canada, Japan, the United Kingdom, the Dominican Republic, the Hong Kong Special Administrative Region of the People’s Republic of China, Germany, Australia and Singapore. In addition, TRL is licensed as a reinsurer in the United Kingdom and TRZ is licensed as a reinsurer in Switzerland. In December 2013, TRL, a subsidiary of TRC formed in the United Kingdom, received authorization to commence writing reinsurance and began binding reinsurance business with effective dates on or after January 1, 2014.
Although Alleghany’s primary sources of revenues and earnings are its reinsurance and insurance operations and investments, it also conducts other activities. Alleghany manages, sources, executes and monitors its private capital investments primarily through its wholly-owned subsidiary, Alleghany Capital Corporation. Alleghany’s private capital investments include: (i) Stranded Oil Resources Corporation (“Stranded Oil”), an exploration and production company focused on enhanced oil recovery, headquartered in Austin, Texas; (ii) Bourn & Koch, Inc. (“BKI”), a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois; (iii) 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; and (iv) an approximately 39 percent equity interest in ORX Exploration, Inc. (“ORX”), a regional oil and gas exploration and production company.
Alleghany also owns and manages properties in the Sacramento, California region through its wholly-owned subsidiary Alleghany Properties Holdings LLC (“Alleghany Properties”).
Net investment income consists primarily of: (i) interest income from debt securities, short-term investments and cash, including any premium or discount amortization; (ii) dividend income from equity securities; and (iii) investment income from other invested assets, which generally includes distributions when receivable and earnings from investments accounted for under the equity method; less expenses related to investments. Interest income is accrued when earned. Premiums and discounts arising from the purchase of certain debt securities are treated as a yield adjustment over the estimated useful life of the securities, adjusted for anticipated prepayments using the retrospective interest method. Under this method, the effective yield on a security is estimated. Such estimates are based on the prepayment terms of the security, past actual cash flows, and assumptions as to future expected cash flow. The future cash flow assumptions consider various prepayment assumptions based on historical experience, as well as current market conditions. Periodically, the effective yield is re-estimated to reflect actual prepayments and updated future cash flow assumptions. Upon a re-estimation, a security’s book value is restated at the most recently calculated effective yield, assuming that yield had been in effect since the security was purchased. This treatment results in an increase or decrease to net investment income (amortization of premium or discount) at the new measurement date.
Valuation service providers typically obtain data about market transactions and other key valuation model inputs from multiple sources and, through the use of widely accepted internal valuation models, provide a single fair value measurement for individual securities for which a fair value has been requested under the terms of service agreements. The inputs used by the valuation service providers include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, currency rates, and other market observable information, as applicable. The valuation models take
into account, among other things, market observable information as of the measurement date as well as the specific attributes of the security being valued including its term, interest rate, credit rating, industry sector, and when applicable, collateral quality and other issue or issuer specific information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.
“Level 1”-Valuations are based on unadjusted quoted prices in active markets that Alleghany has the ability to access for identical, unrestricted assets, and do not involve any meaningful degree of judgment. An active market is defined as a market where transactions for the financial instrument occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Alleghany’s Level 1 assets include publicly traded common stocks and mutual funds (which are included on the balance sheet in equity securities), where Alleghany’s valuations are based on quoted market prices.
Reinsurance is used to mitigate the exposure to losses, manage capacity and protect capital resources. Reinsuring loss exposures does not relieve a ceding entity from its obligations to policyholders and cedants. Reinsurance recoverables (including amounts related to claims incurred but not reported) and ceded unearned premiums are reported as assets. To minimize exposure to losses from a reinsurer’s inability to pay, the financial condition of such reinsurer is evaluated initially upon placement of the reinsurance and periodically thereafter. In addition to considering the financial condition of a reinsurer, the collectibility of the reinsurance recoverables is evaluated (and where appropriate, whether an allowance for estimated uncollectible reinsurance recoverables is to be established), based upon a number of other factors. Such factors include the amounts outstanding, length of collection periods, disputes, any collateral or letters of credit held, and other relevant factors. To the extent that an allowance for uncollectible reinsurance recoverable is established, amounts deemed to be uncollectible are written off against the allowance for estimated uncollectible reinsurance recoverables. Alleghany currently has no allowance for uncollectible reinsurance recoverables. See Note 5 for additional information on reinsurance ceded.
While the reserving process is difficult for insurance business, the inherent uncertainties of estimating loss reserves are even greater for reinsurance business, due primarily to the longer-term nature of much of the reinsurance 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 for classes such as medical malpractice, directors and officers (“D&O”) liability, errors and omissions liability and general liability. 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. See Notes 6 and 12(d) for additional information on loss reserves.
stock dividends. Diluted earnings per share of Common Stock are based on those shares used to calculate basic earnings per share of Common Stock plus the dilutive effect of stock-based compensation awards, retroactively adjusted for stock dividends. See Note 11 for additional information on earnings per share.
In February 2013, the Financial Accounting Standards Board (the “FASB”) issued guidance on the amounts reclassified out of accumulated other comprehensive income. Other comprehensive income includes gains and losses that are initially excluded from net earnings for a given period, and later reclassified out of accumulated other comprehensive income into net earnings. This guidance requires companies to disclose information about reclassifications out of accumulated other comprehensive income in one place. This guidance is effective for interim and annual periods beginning after December 15, 2012. Alleghany adopted this guidance in the first quarter of 2013, and the implementation did not have an impact on its results of operations and financial condition. See Note 10(b).
On November 20, 2011, Alleghany entered into an Agreement and Plan of Merger (the “Merger Agreement”) with its wholly-owned subsidiary, Shoreline Merger Sub, LLC (subsequently converted into a corporation) (“Merger Sub”), and Transatlantic Holdings, Inc. (“Old TransRe”). On the TransRe Acquisition Date, Old TransRe was merged with and into Merger Sub, which was renamed “Transatlantic Holdings, Inc.,” and became a wholly-owned subsidiary of Alleghany.
Following the TransRe Acquisition Date, the Alleghany board of directors consisted of all 11 members from its pre-merger board of directors and three additional members (the “Continuing Directors”) who had served on the board of directors of Old TransRe.
(2) The $816.0 million cash consideration was fixed as of the date of the Merger Agreement, predicated on the 57.4 million shares of common stock of Old TransRe outstanding at that date multiplied by $14.22 per share. Therefore, the additional 0.2 million of Old TransRe shares outstanding as of the TransRe Acquisition Date do not cause the cash consideration to increase and are adjusted for in this presentation.
Pursuant to the terms of the Merger Agreement, each outstanding Old TransRe restricted stock unit (including performance-based Old TransRe restricted stock units) held by current or former employees or non-employee directors of Old TransRe was converted into the right to receive a cash payment in an amount equal to the Per Share Consideration, with the same terms and conditions as were applicable under such restricted stock unit prior to its conversion, that was: (i) deemed notionally invested in the equity of TransRe, referred to as “book value units;” (ii) with respect to the Continuing Directors, deemed notionally invested in Common Stock; or (iii) maintained in a cash account while continuing to vest on the existing vesting schedule. As of the TransRe Acquisition Date, the value of the Old TransRe restricted stock units was determined to be $49.5 million, of which $8.9 million remains unpaid as of December 31, 2013.
The net intangible assets (liabilities) included in “intangible assets” in the table above consist of the following:
TransRe’s results have been included in Alleghany’s Consolidated Financial Statements starting from the TransRe Acquisition Date. The following pro forma financial information for the years ended December 31, 2012 and 2011 is presented for informational purposes only and is not necessarily indicative of the results that would have occurred had the merger been consummated at the beginning of each period presented, nor is it necessarily indicative of future results. Significant assumptions used to determine pro forma results include amortization of intangible assets related to the merger and the assumption that Alleghany’s acquisition of TransRe occurred on January 1 of each of the respective periods (the “Pro Forma TransRe Acquisition Dates”). Transaction Costs and gain on bargain purchase that are included in Alleghany’s financial statements have not been included in the unaudited pro forma consolidated information. The table presents unaudited pro forma consolidated information for the years ended December 31, 2012 and 2011:
(1) Among other adjustments, reflects an increase in amortization expense on TransRe’s AFS debt securities resulting from the adjustment of amortized cost to their fair value as of the Pro Forma TransRe Acquisition Dates. Such adjustment reduced the net investment income of TransRe.
(2) Among other adjustments, reflects adjustments to amortization expense on the TransRe Senior Notes resulting from the adjustment to their fair value as of the Pro Forma TransRe Acquisition Dates. Such adjustment reduced the interest expense of TransRe. See Note 8(b) for additional information on the TransRe Senior Notes. Also reflects adjustments to amortization expense associated with intangible assets arising from the merger.
The pro forma results include TransRe’s pre-tax catastrophe losses, net of reinsurance and reinstatement premiums, of $304.4 million and $851.8 million in 2012 and 2011, respectively. Of the $304.4 million of catastrophe losses incurred in 2012, $53.7 million were incurred by Old TransRe prior to the TransRe Acquisition Date and are not included in Alleghany’s GAAP net earnings for 2012. In addition, TransRe recorded pre-tax losses and LAE of $19.0 million in 2012 related to the capsizing of the luxury liner, Costa Concordia, off the coast of Italy, of which $15.8 million was incurred by Old TransRe prior to the TransRe Acquisition Date and are not included in Alleghany’s GAAP net earnings for 2012.
The amount of goodwill and intangible assets, net of accumulated amortization expense, reported on Alleghany’s consolidated balance sheets as of December 31, 2013 and 2012 is as follows:
(1) Goodwill and intangible assets have been reduced by amounts written-down in prior periods. The 2013 insurance segment intangible assets reflect a $5.0 million non-cash impairment charge recorded in 2013 for certain finite-lived intangible assets at Capitol.
The carrying values and estimated fair values of Alleghany’s consolidated financial instruments as of December 31, 2013 and 2012 were as follows:
(1) This table includes AFS investments (debt and equity securities as well as partnership and non-marketable equity investments carried at fair value that are included in other invested assets). This table excludes investments accounted for using the equity method and certain loans receivable that are carried at cost, all of which are included in other invested assets. The fair value of short-term investments approximates amortized cost. The fair value of all other categories of investments is discussed in Note 1(c).
Alleghany’s financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2013 and 2012 were as follows:
In 2013, there was a transfer of $100.0 million of other invested assets out of Level 3 into common stocks in Level 1 as a previously non-marketable equity investment purchased in early 2013 became publicly traded in an active market that Alleghany has the ability to access. In addition, there was a transfer of $173.1 million of primarily other asset-backed securities out of Level 2 into Level 3 that was principally due to a decrease in observable inputs related to the valuation of such securities. There were no other transfers between Levels 1, 2 or 3 in 2013.
In 2012, there was a transfer of $41.9 million of CMBS-related securities from Level 2 to Level 3 that was principally due to a decrease in observable inputs related to the valuation of such securities and there was a transfer of $267.8 million of U.S. Government obligation-related securities from Level 1 to Level 2, reflecting a change in Alleghany’s classification practice for such securities, effective January 1, 2012, based on a review of trading activity. There were no other transfers among Levels 1, 2 or 3.
The following tables present reconciliations of the changes during 2013 and 2012 in Level 3 assets measured at fair value:
Net unrealized losses related to Level 3 investments as of December 31, 2013 and 2012 were not material.
The amortized cost or cost and the fair value of AFS securities as of December 31, 2013 and 2012 are summarized as follows:
Net investment income for 2013, 2012 and 2011 was as follows:
* See Note 4(h) for discussion of the Pillar Investments and the investment in Ares.
Realized capital gains and losses in 2013, 2012 and 2011 arose primarily from the sales of equity securities. Net realized capital gains in 2013 also include a $46.8 million gain on the sale of Homesite and a $5.0 million non-cash impairment charge related to certain finite-lived intangible assets at Capitol. 2012 includes
To the extent that an equity security in an unrealized loss position is not impaired based on the initial review described above, Alleghany then further evaluates such equity security and deems it to be other-than-temporarily impaired if it has been in an unrealized loss position for 12 months or more or if its unrealized loss position is greater than 50 percent of its cost, absent compelling evidence to the contrary.
the preceding, Alleghany will consider a debt security to be impaired when it believes it to be probable that Alleghany will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, Alleghany develops a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate Alleghany will not recover the full amount of its amortized cost basis in the debt security, Alleghany records an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the debt security. If applicable, the difference between the total unrealized loss position on the debt security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.
OTTI losses for 2013 reflect $44.0 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Upon the ultimate disposition of the securities for which OTTI losses have been recorded, a portion of the loss may be recoverable depending on market conditions at the time of disposition. Of the $44.0 million of OTTI losses, $42.6 million related to equity securities, primarily in the chemical and energy sectors, and $1.4 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in fair value of such securities relative to their cost as of the balance sheet date.
OTTI losses for 2012 reflect $2.9 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $2.9 million of OTTI losses, $1.7 million related to equity securities, primarily in the energy sector, and $1.2 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in fair value of such security relative to their cost as of the balance sheet date.
Alleghany may ultimately record a realized loss after having originally concluded that the decline in value was temporary. Risks and uncertainties are inherent in the methodology Alleghany uses to assess other-than-temporary declines in value. Risks and uncertainties could include, but are not limited to, incorrect assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral, and unfavorable changes in economic conditions or social trends, interest rates or credit ratings.
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, 2013 and 2012 consist of the following:
(4) Represents reinsurance recoverables secured by funds held, trust agreements and letters of credit.
* Include TransRe amounts starting from the TransRe Acquisition Date. See Note 2 for additional information on TransRe.
In the second quarter of 2013, AIHL Re and PCC’s wholly-owned subsidiary, Pacific Compensation Insurance Company (“PCIC”), entered into an intercompany reinsurance contract, effective January 1, 2013, pursuant to which AIHL Re provides PCIC with coverage for adverse development on net loss and allocated loss adjustment expenses in excess of PCIC’s carried reserves at December 31, 2012 and accident year stop-loss coverage for any net losses and allocated loss adjustment expenses in excess of 75.0 percent of net premiums earned for PCIC for accident years 2013, 2014 and 2015. AIHL Re’s commitments also are intended to cover the statutory collateral requirements at PCIC, if and when necessary. AIHL Re’s obligations are subject to an aggregate limit of $100.0 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 PCIC from
Activity in liability for loss and LAE in 2013, 2012 and 2011 is summarized as follows:
(3) 2012 includes amounts from TransRe from the TransRe Acquisition Date through December 31, 2012, including $87.8 million of favorable development from prior accident years on loss and LAE reserves acquired.
The above reserve changes included (decreases) increases in prior year net reserves, which are summarized for 2013, 2012 and 2011 as follows:
The more significant prior year adjustments affecting 2013, 2012 and 2011 are summarized as follows:
Reinsurance Segment - Property. The $184.7 million favorable prior accident year development includes $73.7 million related to Super Storm Sandy. The remaining $111.0 million of favorable development related to catastrophe events prior to 2012, including flooding that took place in Thailand and the Tohoku earthquake in Japan, both of which occurred in 2011, and to prior accident year non-catastrophe reserves from recent accident years. The $184.7 million favorable development in 2013 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods.
On June 26, 2012, Alleghany completed a public offering of $400.0 million aggregate principal amount of its 4.95% senior notes due on June 27, 2022 (the “2022 Senior Notes”). The 2022 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest is payable semi-annually on June 27 and December 27 of each year. The terms of the 2022 Senior Notes permit redemption prior to their maturity. The indenture under which the 2022 Senior Notes were issued contains covenants that impose conditions on Alleghany’s ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2022 Senior Notes were issued at approximately 99.9 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $396.0 million, and an effective yield of approximately 5.05 percent. Approximately $3.6 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2022 Senior Notes.
The higher effective tax rate in 2013 primarily reflects the absence of a gain on bargain purchase, which had a significant impact in 2012. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes. The impact of the gain on bargain purchase on the effective tax rate in 2012 was partially offset by the impact of certain non-deductible Transaction Costs in 2012, which resulted in losses before income taxes without a corresponding decrease in income taxes.
Alleghany filed amended Federal income tax returns and applied for Federal income tax refunds for the tax years 2007 - 2012 related to TransRe’s foreign taxes. To the extent a requested amended return relates to a tax year where the statute of limitations has expired, the filing of the amended return will cause that tax year to re-open.
Alleghany believes that, as of December 31, 2013, 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 was no liability for interest or penalties accrued for uncertain tax positions as of December 31, 2013.
In October 2012, Alleghany’s Board of Directors authorized the repurchase of shares of Common Stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.
Pursuant to the Board authorizations, in 2013, Alleghany repurchased an aggregate of 113,160 shares of its Common Stock in the open market for $40.4 million, at an average price per share of $356.92. In 2012, Alleghany repurchased an aggregate of 53,346 shares of its Common Stock in the open market for $17.8 million, at an average price per share of $333.08. In 2011, Alleghany repurchased an aggregate of 399,568 shares of its Common Stock in the open market for $120.3 million, at an average price per share of $301.14.
Reclassifications out of accumulated other comprehensive income attributable to Alleghany stockholders during 2013 were as follows:
As of December 31, 2013, approximately $6.2 billion of Alleghany’s total equity of $6.9 billion was unavailable for dividends or advances to Alleghany from its subsidiaries. The remaining $0.7 billion was available for dividends or advances to Alleghany from its subsidiaries, or was retained at the Alleghany parent-level, and as such, was available to pay dividends to Alleghany’s stockholders as of December 31, 2013.
With respect to TransRe, its domestic operating subsidiaries could ordinarily pay dividends without regulatory approval based on statutory surplus. However, for a period of 24 months following the TransRe Acquisition Date, TransRe’s operating subsidiaries are prohibited from paying a dividend to TransRe in excess of $200.0 million in any given twelve month period without the prior approval of the New York State Department of Financial Services. In 2013, TRC paid dividends of $200.0 million to TransRe, of which $150.0 million was in turn paid to Alleghany.
The following is a reconciliation of the earnings and share data used in the basic and diluted earnings per share computations for 2013, 2012 and 2011:
Contingently issuable shares of 73,072, 57,981 and 43,292 were potentially available during 2013, 2012 and 2011, respectively, but were not included in the computations of diluted earnings per share because the impact was anti-dilutive to the earnings per share calculation.
On January 30, 2012, Alleghany and the other defendants entered into a memorandum of understanding with the plaintiffs regarding the settlement of these three putative stockholder class actions against Alleghany, Merger Sub, Old TransRe, Old TransRe’s directors, and Allied World Assurance Company Holdings, AG, among others. Pursuant to the terms of the proposed settlement, certain supplemental disclosures were made related to the merger. The memorandum of understanding contemplated that the parties would enter into a stipulation of settlement. On October 12, 2012, the parties entered into a stipulation of settlement that includes customary conditions, including court approval following notice to Old TransRe’s stockholders. On January 10, 2013, a hearing was held before the Court to consider the fairness, reasonableness, and adequacy of the settlement, as well as plaintiffs’ counsel’s petition for an award of attorneys’ fees and expenses not to exceed $0.5 million, to be paid, or cause to be paid, by TransRe. At the hearing, the Chancellor declined to approve the settlement, but granted plaintiffs’ counsel an opportunity to make a supplemental submission addressing, among other things, the materiality of the supplemental disclosures made in connection with the settlement. On January 29, 2013, the plaintiffs filed such supplemental submission. On February 28, 2013, another hearing was held before the Court to consider the proposed settlement. At that hearing, the Court declined to approve the
On January 26, 2012, TransRe reached an agreement with AIG to settle and mediate a dispute previously in arbitration, which arose as a result of losses claimed by TransRe from its participation in a securities lending program administered and managed by AIG. On July 20, 2012, in accordance with the agreement between the parties, a mediator awarded TransRe a settlement payment of $75.0 million with respect to the securities lending claim. In connection with its accounting for the acquisition of TransRe, Alleghany established an asset of $36.0 million, representing an estimate based on the minimum recovery previously agreed to by the parties, net of estimated legal costs. A pre-tax net benefit of approximately $23.5 million resulting from this settlement was recorded as other income in 2012, representing the portion of the settlement payment above such minimum recovery, net of additional estimated legal costs.
Alleghany leases 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 2029. Rent expense was $28.8 million, $21.2 million and $10.5 million in 2013, 2012 and 2011, respectively. The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2013 were as follows:
The reserves carried for such claims, including the incurred but not reported 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 and environmental impairment losses, particularly for those occurring in 1985 and prior, which represents 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.
Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, Alleghany classifies its business into two reportable segments - reinsurance and insurance. In addition, reinsurance and insurance underwriting activities are evaluated separately from investment and
The insurance segment consists of property and casualty insurance operations conducted by AIHL through its insurance operating subsidiaries RSUI, Capitol and PCC. RSUI also writes a modest amount of assumed reinsurance business, which is included in the insurance segment.
In addition, corporate activities includes interest expense associated with the Alleghany Senior Notes, whereas interest expense associated with the TransRe Senior Notes is included in “Total Segments.”
(4) 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 income, other operating expenses, amortization of intangible assets or interest expense. Underwriting profit does not replace earnings before
income taxes determined in accordance with GAAP as a measure of profitability. Rather, Alleghany believes that underwriting profit enhances the understanding of its segments’ operating results by highlighting net earnings attributable to their underwriting performance. Earnings before income taxes (a GAAP measure) may show a profit despite an underlying underwriting loss. Where underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. Therefore, Alleghany views underwriting profit as an important measure in the overall evaluation of performance.
Information associated with Alleghany’s foreign operations, which relates to its reinsurance segment, is as follows:
Foreign gross premiums written in 2013 and from the TransRe Acquisition Date through December 31, 2012 were $1,645.5 million and $1,454.9 million, respectively.
As of December 31, 2013, the identifiable assets of the reinsurance segment, insurance segment and corporate activities were $16.5 billion, $6.3 billion and $0.6 billion, respectively, of which cash and invested assets represented $14.5 billion, $4.7 billion and $0.3 billion, respectively. As of December 31, 2013, Alleghany’s equity attributable to the reinsurance segment, insurance segment and corporate activities was $4.5 billion, $2.7 billion and ($0.3) billion, respectively.
Amounts recognized as compensation expense in the consolidated statements of earnings and comprehensive income with respect to long-term compensation awards under plans for parent-level employees and directors were $18.7 million, $19.4 million and $2.8 million in 2013, 2012 and 2011, respectively. The amount of related income tax benefit recognized as income in the consolidated statements of earnings and comprehensive income with respect to these plans was $6.5 million, $6.8 million and $1.0 million in 2013, 2012 and 2011, respectively. In 2013, 2012 and 2011, $6.4 million, $4.9 million and $1.8 million of Common Stock at
The automatic annual grant to each non-employee director consists of either restricted stock 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, 2013.
TransRe has a Book Value Unit Plan (the “TransRe Plan”) for the purpose of providing equity-like incentives to key employees of TransRe. Under the TransRe Plan, book value units (“BVUs”) are issued. BVUs may only be settled in cash. The fair value of each BVU is calculated as stockholder’s equity of TransRe, adjusted for certain capital transactions, divided by the adjusted number of BVUs outstanding. Pursuant to the terms of the Merger Agreement, certain Old TransRe restricted stock units held by current or former employees were converted into BVUs. BVUs have vesting dates of up to the fourth anniversary of the date of grant, with converted Old TransRe restricted stock units retaining their pre-conversion vesting dates. The BVUs contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2013 and 2012, TransRe recorded $52.2 million and $63.9 million, respectively, in compensation expense and a deferred tax benefit of $18.3 million and $22.4 million, respectively, related to the TransRe Plan.
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 2013, 2012 and 2011 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 2013, 2012 and 2011, RSUI recorded $27.9 million, $21.0 million and $26.2 million, respectively, in compensation expense related to the RSUI Plan. During the same periods, a deferred tax benefit of $9.8 million, $7.4 million and $9.2 million, respectively, related to the compensation expense was recorded.
In addition, Alleghany has defined benefit pension and, prior to September 30, 2013, retiree health plans for parent-level employees, and TransRe and Kentucky trailer have defined benefit pensions plans for certain of its employees, as further described below.
Kentucky Trailer has a funded noncontributory defined benefit plan for some of its employees. Benefits under Kentucky Trailer’s defined benefit plans were frozen in 2005. As of December 31, 2013, the projected benefit obligation was $5.6 million, and the related fair value of plan assets was $4.7 million.
(2) Earnings per share by quarter may not equal the amount for the full year due to the timing of both the shares issued in connection with the merger in 2012 and repurchases of Common Stock, as well as rounding.
We have audited Alleghany Corporation and subsidiaries internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (the COSO criteria). Alleghany Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2013 of Alleghany Corporation and subsidiaries and our report dated February 25, 2014 expressed an unqualified opinion thereon.