changes in market prices of our significant equity investments and changes in value of our debt securities portfolio;
As noted above, as of any balance sheet date, not all claims that have occurred have been reported to our insurance operating units, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled by the insurer is referred to as the “claim tail.” Property claims usually have a fairly short claim tail and, absent claim litigation, are reported and settled within no more than a few years of the date they occur. 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, rather than determining an expected loss ratio for the current business. 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, historical data, legal developments, and economic conditions, including the effects of inflation. As of December 31, 2011, the amount of IBNR for short-tail claims represented approximately 1.3 percent, or $29.7 million, of our total gross loss and LAE liabilities of $2.3 billion. In conformity with GAAP, our insurance operating units are not permitted to establish IBNR reserves for catastrophe losses that have not occurred. Therefore, losses related to a significant catastrophe, or accumulation of catastrophes, in any reporting period could have a material, negative impact on our results during that period.
Although we are unable at this time to determine whether additional reserves, which could have a material impact upon our financial condition, results of operations, and cash flows, may be necessary in the future, we believe that the reserves for unpaid loss and LAE established by our insurance operating units are adequate as of December 31, 2011.
Each of the above actuarial assumptions may also incorporate data from the insurance industry as a whole, or peer companies writing substantially similar insurance coverages, in the absence of sufficiently credible internally-derived historical information. Data from external sources may be used to set expectations, as well as assumptions regarding loss frequency or severity relative to an exposure unit or claim, among other actuarial parameters. Assumptions regarding the application or composition of peer group or industry reserving parameters require substantial judgment. The use of data from external sources was most significant for PCC as of December 31, 2011.
Sensitivity. 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 and 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 insurance operating units. The length of the loss reporting lag affects our ability to accurately predict loss frequency (loss frequencies 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 2011 (dollars in millions):
Our net reserves for loss and LAE of $1.5 billion as of December 31, 2011 relate to multiple accident years. Therefore, the impact of changes in frequency or severity for more than one accident year could be higher or lower than the amounts reflected above. We believe the above analysis provides a reasonable benchmark for sensitivity as we believe it is within historical variation for our reserves. Currently, none of the scenarios is believed to be more likely than the other. See Note 1(j) and Note 6 to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report for additional information on our loss and LAE.
Prior Year Development. Our insurance operating units 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 year reserve development. Each of RSUI, CATA and PCC adjusted its prior year loss and LAE reserve estimate during 2011 and 2010 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 (in millions):
• For CATA, loss and LAE for 2011 reflect a net $5.0 million increase of prior accident year loss reserves (related primarily to the casualty lines of business), compared with a $0.4 million release of prior accident year loss reserves during 2010 (related primarily to the surety lines of business). The $5.0 million net reserve increase consists of a $14.6 million increase in reserves related to certain specialty property and casualty classes of business through a program administrator in connection with a program where notice of termination of such program has been given (“Terminated Program Business”), partially offset by a $9.6 million of net reserve release in certain of CATA’s casualty lines of business. The reserve increase in the Terminated Program Business reflects unfavorable loss emergence, primarily in the 2009 and 2010 accident years, compared with loss emergence patterns assumed in earlier periods for such business. The net $5.0 million increase of prior accident year loss reserves did not impact the assumptions used in estimating CATA’s loss and LAE liabilities for business earned in 2011.
• For PCC, loss and LAE for 2011 reflect a $28.4 million increase of prior accident year workers’ compensation loss reserves, compared with a $12.5 million reserve increase of prior accident year workers’ compensation loss reserves during 2010. Of the $28.4 million increase, $15.0 million was recorded in the 2011 second quarter and $13.4 million was recorded in the 2011 fourth quarter, as follows (in millions):
second quarter 2011 review of reinsurance coverage estimates, which also resulted in a $1.1 million decrease in ceded premiums earned, thereby increasing net premiums earned in the 2011 second quarter.
For PCC, the $12.5 million increase in loss and LAE for 2010 relates primarily to a decrease in ceded loss and LAE reserves based on a fourth quarter 2010 review of reinsurance coverage estimates, and to a lesser extent, an increase in unallocated LAE reserves, which also resulted in a $5.0 million decrease in ceded premiums earned, thereby increasing net premiums earned in 2010.
Asbestos and Environmental Impairment Reserves. Our reserve for unpaid loss and LAE includes $13.7 million of gross and net reserves as of December 31, 2011 for asbestos and environmental impairment claims that arose from reinsurance of certain general liability and commercial multiple peril coverages assumed by Capitol Indemnity between 1969 and 1976. Reserves for asbestos and environmental impairment claims cannot be estimated with traditional loss reserving techniques because of uncertainties that are greater than those associated with other types of claims. Factors contributing to these uncertainties include a lack of historical data, the significant periods of time that often elapse between the occurrence of an insured loss and the reporting of that loss to the ceding company and the reinsurer, uncertainty as to the number and identity of insureds with potential exposure to these risks, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Loss reserve estimates for these asbestos and environmental impairment exposures include case reserves, which also reflect reserves for legal and other LAE and IBNR reserves. IBNR reserves are determined based upon CATA’s historic general liability exposure base and policy language, asbestos liability law, judicial settlements of asbestos liabilities, previous environmental impairment loss experience, the assessment of current trends of environmental law and environmental cleanup costs.
Reinsurance. Recoverables recorded with respect to claims ceded by our insurance operating units 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 the reinsurer is unable to perform under the contract. Reinsurance contracts purchased by our insurance operating units do not relieve them of their obligations to their own policyholders. Additional information regarding the use of, and risks related to, the use of reinsurance by our insurance operating units can be found on pages 23 through 25 and page 33 of this Form 10-K Report. Also see Note 1(e) and Note 5 to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report for additional information on our reinsurance recoverables.
continue to hold the applicable security. In addition, under GAAP, any portion of such decline that relates to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income.
(iii) it is more likely than not that we will sell a debt security before recovery of its amortized cost basis.
We then evaluate all remaining equity securities that are in an unrealized loss position the cost of which:
(ii) current views on the equity security, as expressed by either our internal stock analysts and/or by independent stock analysts or rating agencies; and
(iii) discrete 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.
To the extent that a debt security that is in an unrealized loss position is not impaired based on the initial review described above, and absent an intent to sell, we will consider a debt security to be impaired when we believe it to be probable that we will not be able to collect all amounts due under the security’s contractual terms.
See Note 1(b) and Note 3 to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report for additional information on our investments and investment impairments.
Our consolidated balance sheet as of December 31, 2011 includes goodwill and other intangible assets, net of amortization, of $139.0 million, and related to RSUI and CATA. This amount has been recorded as a result of business acquisitions. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and other intangible assets deemed to have an indefinite useful life are tested annually in the fourth quarter of every calendar year for impairment and at such other times upon the occurrence of certain events. We also evaluate goodwill and other intangible assets whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. A significant amount of judgment is
See Note 1(h), Note 1(o) and Note 4 to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report for additional information on our goodwill and other intangible assets.
We file a consolidated federal income tax return with our subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. As of December 31, 2011, a net deferred tax asset of $81.0 million was recorded, which included a valuation allowance of $15.2 million for certain deferred state tax assets which we believe may not be realized. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. This determination is based upon a review of anticipated future earnings as well as all available evidence, both positive and negative.
We are engaged, through AIHL and its subsidiaries, primarily in the property and casualty and surety insurance business. We also own and manage land in the Sacramento, California region through our subsidiary Alleghany Properties and seek out strategic investments and conduct other activities at the parent level. Primarily
The profitability of our insurance operating units is also impacted by competition generally and price competition in particular. Historically, the performance of the property and casualty insurance industry has tended to fluctuate in cyclical periods of price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. Although an individual insurance company’s performance is dependent on its own specific business characteristics, the profitability of most property and casualty insurance companies tends to follow this cyclical market pattern. In the past few years, our insurance operating units have faced increasing competition as a result of an increased flow of capital into the insurance industry, with both new entrants and existing insurers seeking to gain market share. This resulted in decreased premium rates and less favorable contract terms and conditions. In particular, RSUI and CATA’s specialty lines of business increasingly encountered competition from the standard market. Although we continue to see a competitive property and casualty insurance market, we continue to be cautiously optimistic about the prospect for improvements, particularly in property insurance and workers’ compensation pricing.
* Corporate activities consist of Alleghany Properties, our investments in Homesite and ORX and corporate activities at the parent level.
quarter when we incurred substantial losses primarily related to a significant deterioration of U.S. equity and, to a lesser extent, residential housing market conditions.
The effective income tax rate on earnings before income taxes was 24.9 percent in 2011, 28.4 percent in 2010 and 31.5 percent in 2009. The lower effective tax rate in 2011 primarily reflects the impact of higher dividends received deductions and lower pre-tax earnings in 2011, partially offset by the absence of a foreign tax benefit which was significant in 2010. The lower effective income tax rate in 2010 compared with 2009 primarily reflects the recognition of a permanent tax benefit in the 2010 first quarter. This permanent tax benefit related to a finalization of our unused foreign tax credits arising from our prior ownership of World Minerals, Inc. which was sold on July 14, 2005. The lower effective income tax rate in 2010 compared with 2009 also reflects increased tax benefits associated with dividends and tax-exempt income.
(2) Commission, brokerage and other underwriting expenses represent commission and brokerage expenses and that portion of salaries, administration and other operating expenses attributable primarily to underwriting activities, whereas the remainder constitutes other expenses.
(4) Loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.
(5) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.
The increase in gross premiums written by RSUI in 2011 from 2010 primarily reflects the impact of assumed premium writings from international insurance carriers, and, to a lesser extent, growth in binding authority business. Such increases were partially offset by the impact of reduced exposures of RSUI’s customers and continuing competition in certain of RSUI’s casualty lines of business. The slight increase in RSUI’s net premiums earned in 2011 from 2010 primarily reflects the impact of a recent increase in gross premiums written, largely offset by the impact of lower gross premiums written during the third and fourth quarters of 2010 and the first quarter of 2011 as compared with gross premiums written in the third and fourth quarters of 2009 and the first quarter of 2010.
The increase in loss and LAE in 2011 from 2010 primarily reflects the impact of higher catastrophe and other large property losses, partially offset by the impact of higher releases of prior accident year reserves in 2011 (as further described below). Catastrophe losses, net of reinsurance, were $74.3 million in 2011, compared with $31.0 million in 2010. Catastrophe losses in 2011 primarily reflect net losses from severe weather, particularly tornados, in the southeastern and midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the east coast of the U.S. in August 2011. Catastrophe losses in 2011 also include assumed catastrophe losses from international insurance carriers. In addition, RSUI incurred a net $14.4 million property loss arising from the magnitude 5.8 earthquake that occurred in Northern Virginia in August 2011. This earthquake was not classified as a catastrophic event by the property and casualty industry.
The decrease in loss and LAE in 2010 from 2009 primarily reflects the impact of lower net premiums earned and lower non-catastrophe property losses incurred, partially offset by $31.0 million of catastrophe losses
For RSUI, loss and LAE for 2011 reflect a net $56.2 million release of prior accident year casualty loss reserves, compared with a net $33.9 million release during 2010 and a net $38.4 million release during 2009. The $56.2 million release relates primarily to the umbrella/excess, general liability and professional liability lines of business, primarily for the 2003 through 2008 accident years, and reflects favorable loss emergence, compared with loss emergence patterns assumed in earlier periods for such lines of business. Such reserve releases were partially offset by an increase in loss reserves in the D&O liability line of business in the 2011 third quarter, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year. The $33.9 million net release of prior year casualty loss reserves in 2010 consisted of a $41.4 million reserve release, partially offset by a $7.5 million reserve increase. The $41.4 million reserve release during 2010 and the net $38.4 million reserve release during 2009 primarily reflect favorable loss emergence compared with loss emergence patterns assumed in earlier periods.
The increase in commissions, brokerage and other underwriting expenses in 2011 compared with 2010 is due primarily to growth in the binding authority business, which incurs higher commission and other underwriting expenses than other lines of business. The decrease in commissions, brokerage and other underwriting expenses in 2010 compared with 2009 primarily reflects the net effect of lower premium volumes described above, which caused premium taxes, commissions and related acquisition costs to decline.
Additional information regarding RSUI’s use of reinsurance and risks related to reinsurance recoverables can be found on pages 23 through 25 and page 33 of this Form 10-K Report. Additional information regarding RSUI’s prior year reserve adjustments and releases can be found on pages 45 and 46 of this Form 10-K Report.
Although we continue to see a competitive property and casualty insurance market, we continue to be cautiously optimistic about the prospect for improvements, particularly in property insurance pricing.
The decrease in gross premiums written by CATA in 2011 from 2010 primarily reflects continuing price competition in CATA’s property and casualty lines of business, including in excess and surplus markets, partially offset by higher gross premiums written in CATA’s commercial surety line of business. The decrease in CATA’s property and casualty lines of business also reflects reduced writings associated with CATA’s Terminated Program Business. CATA’s net premiums earned decreased in 2011 from 2010 primarily reflecting the decrease in gross premiums written.
The decrease in loss and LAE in 2011 from 2010 primarily reflects the impact of lower net premiums earned, partially offset by the impact of a net reserve increase of prior accident year loss reserves in 2011 compared with a net reserve release in 2010 (as further described below). The increase in loss and LAE in 2010 from 2009 primarily reflects a lower amount of prior year reserve releases in 2010 compared with 2009 (as further described below), and to a lesser extent, higher property and workers’ compensation claims.
For CATA, loss and LAE for 2011 reflect a net $5.0 million increase of prior accident year loss reserves (related primarily to the casualty lines of business), compared with a $3.9 million release of prior accident year loss reserves during 2010 and a $10.7 million release of prior accident year loss reserves during 2009. The $5.0 million net reserve increase was due primarily to a $14.6 million increase in reserves related to CATA’s Terminated Program Business, partially offset by a $9.6 million net reserve release in certain of CATA’s casualty lines of business. The $3.9 million release in 2010 includes $3.5 million reserve release reflecting favorable loss emergence for asbestos and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976, based on a reserve study that was completed in the 2010 second quarter. The $10.7 million reserve release in 2009 primarily reflects favorable emergence in the casualty and surety lines of business.
Additional information regarding CATA’s prior year reserve releases can be found on pages 45 and 46 of this Form 10-K Report.
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 difficult state of the California workers’ compensation market and took corresponding expense reduction steps, including staff reductions, in light of such determination. PCC also took steps to emerge as a brokerage carrier at such time as it determines rates are adequate. In 2011, PCC began writing a modest amount of new business through brokers.
PCC reported underwriting losses of $51.6 million, $30.5 million and $70.7 million in 2011, 2010 and 2009, respectively. The underwriting losses primarily reflect an absence of premiums earned for the reasons described above (particularly with respect to the 2011 and 2010), combined with PCC’s ongoing staffing and related expenses. The underwriting losses also reflect the impact of increases of prior accident year loss reserves in each period (as further described below).
For PCC, loss and LAE for 2011 reflect a $28.4 million increase of prior accident year workers’ compensation loss reserves, compared with a $12.5 million reserve increase of prior accident year workers’ compensation loss reserves during 2010. Of the $28.4 million increase, $15.0 million was recorded in the 2011 second quarter and $13.4 million was recorded in the 2011 fourth quarter, as follows (in millions):
PCC’s adverse claims emergence relates to an unanticipated increase in medical claims emergence and an absence of anticipated favorable indemnity claims emergence. PCC had anticipated favorable indemnity claims emergence based upon prior claims development experience which indicated that injured workers would be returning to work, curtailing lost wage costs. PCC believes the weak California employment environment has hindered the ability of injured workers to return to work and indirectly influenced indemnity claims. The
increases in allocated and unallocated LAE reserves primarily reflect increased use of outside counsel to assist in the settlement process and higher litigation costs caused by recent Workers’ Compensation Appeals Board decisions. The decrease in ceded loss and LAE reserves was based on a second quarter 2011 review of reinsurance coverage estimates, which also resulted in a $1.1 million decrease in ceded premiums earned, thereby increasing net premiums earned in the 2011 second quarter.
The California Department of Insurance, or the “CDI,” is responsible for periodic financial and market conduct examinations of California-domiciled insurance companies. In September 2010, the CDI issued a financial examination report of PCIC for the period from July 1, 2004 through December 31, 2008. As part of its work for such financial examination report, the CDI produced an actuarial report, or the “Actuarial Report,” for the years ended December 31, 2009 and 2008. The Actuarial Report included an estimate of loss and LAE reserves on a statutory basis of accounting that was higher than that recorded by PCIC at such dates. We believed that PCIC’s reserves for unpaid loss and LAE were adequate, and the CDI did not require PCIC to currently or retroactively increase its carried reserves to the estimates included in the Actuarial Report. AIHL did, however, contribute $40.0 million of capital to PCC on September 27, 2010, and these funds were used by PCIC to increase its workers’ compensation deposit, which is required to be maintained by PCIC under California workers’ compensation regulations, to a level consistent with the estimated loss and LAE reserves included in the Actuarial Report. To the extent that PCIC’s actual loss experience is less than the CDI’s final estimate of PCIC’s loss and LAE reserves, over time such additional workers’ compensation deposit funds will be released back to PCIC.
* Excludes a non-cash impairment charge in 2009 related to the intangible assets associated with our acquisition of PCC which was classified as a net realized capital loss in our consolidated statements of earnings (see Note 4(a) to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report).
(1) Average of amortized cost of debt securities portfolio at beginning and end of period.
(2) After investment expenses, excluding net realized gains and other-than-temporary impairment losses.
The decrease in losses in 2011 from 2010 primarily reflects higher net realized capital gains, partially offset by higher corporate administration and other expenses, higher interest expenses, lower other income and higher negative net investment income. Net realized capital gains in 2011 primarily reflects net realized capital gains from the sale of equity securities, primarily common stock of Exxon Mobil Corporation in the fourth quarter of 2011. The proceeds from such sales were reinvested in short-term securities and cash, and will be used to fund Alleghany’s cash consideration in connection with the pending merger with Transatlantic, which is expected to close in the first quarter of 2012. The higher corporate administration and other expenses is due primarily to $19.3 million of due diligence, legal, investment bank and other costs incurred in the 2011 fourth quarter related to the pending merger with Transatlantic, partially offset by lower incentive compensation and pension accruals. The higher interest expenses are due to our Senior Notes, which were issued on September 20, 2010. The lower other income in 2011 reflects the absence of a non-recurring gain from Alleghany Properties that existed in 2010. As further explained below, the increase in negative net investment income is due primarily to higher catastrophe losses related to our investment in Homesite, partially offset by higher dividend income and higher interest income. Higher interest income reflects the investment of the proceeds from our Senior Notes and dividends received from subsidiaries. For more information on the merger, see Note 2 to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report.
Net investment income for Corporate activities includes our equity share of (losses) earnings in Homesite and ORX, as follows (in millions):
Homesite losses in 2011 primarily reflect the impact of increased homeowners insurance claims from severe weather, particularly tornados, in the southeastern and midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the east coast of the U.S. in August 2011. Homesite losses in 2011 also reflect a tax valuation adjustment that Homesite recorded in the fourth quarter of 2011. Homesite losses in 2010 and 2009 primarily reflect the impact of increased homeowners insurance claims from severe weather and ongoing purchase accounting adjustments.
The $21.9 million losses in 2009 for ORX were due primarily to asset impairment charges incurred as of December 31, 2008, but finalized in the 2009 third quarter, arising from relatively low energy prices as of December 31, 2008.
AIHL’s insurance operating units analyze, at least quarterly, liabilities for unpaid loss and LAE established in prior years and adjust their expected ultimate cost, 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 year reserve development. The following table presents the reserves established in connection with the loss and LAE of AIHL’s insurance operating units on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate loss (including for IBNR) and LAE.
(3) Workers’ compensation amounts include PCC, net of purchase accounting adjustments (see Note 4(a) to the Consolidated Financial Statements set forth in Item 8 of this Form 10-K Report). Such adjustments include a minor reduction of gross and net loss and LAE for acquisition date discounting, as required under purchase accounting. Workers’ compensation amounts also include minor balances from CATA.
(4) Primarily consists of 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. The loss and LAE reserves are ceded 100 percent to the sellers. Additional information regarding the loss reserve guarantees can be found in Note 5(c) to the Consolidated Financial Statements set forth in Item 8 of this 10-K Report.
Gross Reserves. Gross loss and LAE reserves as of December 31, 2011 decreased slightly from December 31, 2010, primarily reflecting reserve decreases in the casualty and workers’ compensation lines of business, largely offset by reserve increases in the property lines of business. The decrease in the casualty gross loss and LAE reserves primarily reflects the impact of releases in gross loss and LAE reserves by RSUI during 2011 related to prior accident years, partially offset by the impact of increases in gross loss and LAE reserves by CATA during 2011 related to prior accident years. The decrease in workers’ compensation gross loss and LAE reserves primarily reflects the impact of PCC ceasing to solicit new or renewal business on a direct basis commencing August 1, 2009, partially offset by an increase in gross loss and LAE reserves by PCC as of June 30, 2011 and December 31, 2011 related to prior accident years. The increase in property gross loss and LAE reserves is due to increases in case reserves related primarily to significant catastrophe and other large losses incurred in 2011, partially offset by claim payments made by RSUI in 2011 related to catastrophe losses in prior years. Such claim payments caused RSUI to reduce its case reserves from prior accident years, primarily related to 2008 third quarter hurricane losses.
Net Reserves. Net loss and LAE reserves as of December 31, 2011 were essentially unchanged from December 31, 2010, primarily reflecting reserve decreases in the casualty and workers’ compensation lines of business and offsetting reserve increases in the property lines of business. The decrease in the casualty net loss and LAE reserves primarily reflects the impact of releases in net loss and LAE reserves by RSUI during 2011 related to prior accident years, partially offset by the impact of increases in net loss and LAE reserves by CATA during 2011 related to prior accident years. The decrease in workers’ compensation net loss and LAE reserves primarily reflects the impact of PCC ceasing to solicit new or renewal business on a direct basis commencing August 1, 2009, partially offset by an increase in net loss and LAE reserves by PCC as of June 30, 2011 and December 31, 2011 related to prior accident years. The increase in property net loss and LAE reserves is due to increases in case reserves related primarily to significant catastrophe and other large losses incurred in 2011, partially offset by claim payments made by RSUI in 2011 related to catastrophe losses in prior years. Such claim payments caused RSUI to reduce its case reserves from prior accident years, primarily related to 2008 third quarter hurricane losses, after reflecting any applicable ceded reinsurance.
Changes in Loss and LAE Reserves between December 31, 2010 and December 31, 2009
Gross Reserves. Gross loss and LAE reserves as of December 31, 2010 decreased from December 31, 2009 due primarily to reserve decreases in property and workers’ compensation lines of business. The decrease in property gross loss and LAE reserves is mainly due to loss payments made by RSUI on hurricane related losses incurred in prior years. The decrease in workers’ compensation gross loss and LAE reserves primarily reflects the impact of PCC’s decision in June 2009 to cease soliciting new or renewal business on a direct basis commencing August 1, 2009.
Additional information regarding RSUI’s net prior year reserve releases and PCC’s current and prior year reserve increases can be found on pages 45 through 47 of this Form 10-K Report.
As of December 31, 2011, AIHL had total reinsurance recoverables of $852.8 million, consisting of $831.8 million of ceded outstanding loss and LAE and $21.0 million of recoverables on paid losses. RSUI’s reinsurance recoverables totaled $759.8 million of AIHL’s $852.8 million. The reinsurance purchased by AIHL’s insurance operating units does not relieve them from their obligations to their policyholders, and therefore, the financial strength of their reinsurers is important. AIHL’s Reinsurance Security Committee, which includes certain of our officers and the chief financial officer of each of AIHL’s operating units and which manages the use of reinsurance by such operating units, has determined that reinsurers with a rating of A (Excellent) or higher have an ability to meet their ongoing obligations at a level that is acceptable to us.
resulting in proceeds before 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 was recorded as deferred charges, which are amortized over the life of the Senior Notes.
Credit Agreement. On September 9, 2010, we entered into the Credit Agreement, and a related security agreement, or the “Security Agreement,” with a bank syndicate. The Credit Agreement provides for a two tranche revolving credit facility in an aggregate principal amount of up to $100.0 million, or the “Commitments,” consisting of (i) a secured credit facility, or “Tranche A,” subject to a borrowing base as set forth in the Credit Agreement, in an aggregate principal amount of up to $50.0 million and (ii) an unsecured credit facility, or “Tranche B,” in an aggregate principal amount of up to $50.0 million. The Commitments under the Credit Agreement are scheduled to terminate on September 9, 2013, or the “Maturity Date,” unless earlier terminated. Borrowings under the Credit Agreement are available for working capital and general corporate purposes.
Alternate Base Rate Borrowings under the Credit Agreement bear interest at (x) the greatest of (a) the administrative agent’s prime rate, (b) the federal funds rate plus 0.5 percent or (c) an adjusted London Interbank Overnight, or “LIBO,” rate for a one month interest period on such day plus 1 percent, plus (y) a specified margin (currently 0 basis points for Tranche A and 125 basis points for Tranche B). Eurodollar Borrowings under the Credit Agreement bear interest at the Adjusted LIBO Rate for the interest period in effect plus a specified margin (currently 75 basis points for Tranche A and 225 basis points for Tranche B). The Credit Agreement requires that all loans be repaid in full no later than the Maturity Date. The Credit Agreement also requires us to pay a Commitment Fee each quarter in a range of between one fifth and one-half of one percent per annum, based upon our Moody’s Rating and S&P Ratings Services, on the daily unused amount of the Commitments of the relevant Tranche.
The Security Agreement secures all of our obligations relating to the Tranche A Loans under the Credit Agreement, and grants to a collateral agent for the Lenders, or “Collateral Agent,” a continuing first priority lien on and security interest in, and assigns to the Collateral Agent (for the ratable benefit of the Lenders) as collateral security, all of our right, title and interest in and to: (i) all cash, securities, shares of stock, investment property, financial assets, equity interests, instruments and general intangibles which are from time to time held in or credited to a certain account, or the “Account,” maintained with the Collateral Agent, (ii) the Account itself, and (iii) all rights to which we now or hereafter become entitled by reason of our interest in any of the previously described collateral, and all security entitlements related to the Account and the financial assets credited to the Account, and the additions to, accessions to, substitutions of, products or proceeds of any or all of the foregoing.
Dividends. We have declared stock dividends in lieu of cash dividends every year since 1987 except 1998 when our wholly-owned subsidiary, Chicago Title Corporation, was spun off to our stockholders. These stock dividends have helped to conserve our financial strength and, in particular, the liquid assets available to finance internal growth and operating company acquisitions and investments. In light of the pending merger with Transatlantic, our Board of Directors determined not to declare a stock dividend for 2012.
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2011, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows (in millions):
Our insurance operating units have obligations to make certain payments for loss and LAE pursuant to insurance policies they issue. These future payments are reflected as reserves on our consolidated financial statements. With respect to loss and LAE, there is typically no minimum contractual commitment associated with insurance contracts, and the timing and ultimate amount of actual claims related to these reserves is uncertain. Additional information regarding reserves for loss and LAE, including information regarding the timing of payments of these expenses, can be found on pages 19 through 22, pages 30 and 31, pages 42 through 47 and pages 60 and 61 of this Form 10-K Report.
Off-Balance Sheet Arrangements. In late 2010, Alleghany Properties commenced making investments in three California low income housing tax credit limited liability companies. The investments each took the form of a limited partnership interest in separate limited liability companies organized and managed by a third party real estate developer. Alleghany Properties expects that its investment in the limited liability companies will last for approximately 10 years. The developer is the general partner and retains the residual interest in the underlying real estate properties. The limited liability companies are consolidated by the third party real estate developer for accounting purposes. Funding for each low income housing project is provided principally by Alleghany Properties and various government-sponsored loans secured by the assets of the limited liability companies. As of December 31, 2011, Alleghany Properties invested a cumulative $4.5 million in the three limited liability companies, and is committed to invest an additional $1.7 million.
denominated in U.S. dollars, investments may be made in other currency denominations depending upon investment opportunities in those currencies, or as may be required by regulation or law.
Fair Value. The estimated carrying values and fair values of our consolidated financial instruments as of December 31, 2011 and December 31, 2010 were as follows (in millions):
“Level 2” - Valuations are based on quoted market prices where such markets are not deemed to be sufficiently “active.” In such circumstances, additional valuation metrics will be used which involve direct or indirect observable market inputs. Our Level 2 assets generally include preferred stocks and debt securities other than debt issued directly by the U.S. Government. Our Level 2 liabilities include
Mortgage-and Asset-Backed Securities. As of December 31, 2011, our mortgage-and asset-backed securities portfolio consisted of the following and was backed by the following types of underlying collateral (in millions):
In December 2011, the FASB issued guidance on disclosure requirements related to offsetting arrangements. This guidance provides for additional financial statement disclosure regarding offsetting and related arrangements to enable financial statement users to understand the effect of those arrangements on an entity’s financial position. This guidance is effective for interim and annual reporting periods beginning on or after January 1, 2013. We will adopt this guidance in the 2013 first quarter, and we do not currently believe that its implementation will have an impact on our results of operations and financial condition.
In October 2010, the FASB issued guidance that provides additional clarification for costs associated with acquiring or renewing insurance contracts. This guidance states that only incremental, direct costs associated with the successful acquisition of a new or renewal insurance contract may be capitalized as deferred acquisition costs. Furthermore, such costs: (i) must be essential to the contract transaction; (ii) would not have been incurred had the contract transaction not occurred; and (iii) must be related directly to the acquisition activities involving underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Advertising costs should be included in deferred acquisition costs only if the capitalization criteria in separate “direct response” advertising guidance within GAAP are met. All other acquisition-related costs and other expenses should be charged to expense as incurred. This guidance is effective for interim and annual periods beginning after December 15, 2011, with early adoption permitted (but only at the beginning of an entity’s annual reporting period). We will adopt this guidance prospectively in the 2012 first quarter, and we do not currently believe that its implementation will have a material impact on our results of operations and financial condition.
On November 20, 2011, Alleghany signed a merger agreement with Transatlantic Holdings, Inc. (“Transatlantic”). The merger is expected to close in the first quarter of 2012. See Note 2 for further details.
As of December 31, 2011 and 2010, available-for-sale securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to available-for-sale securities, 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 the decline in fair value is deemed to be other than temporary, its cost-basis is written down to the fair value of the investment and recorded as an other-than-temporary impairment loss on the statement of earnings. In addition, any portion of such decline that relates to debt securities that is believed to arise from factors other than credit is to be recorded as a component of other comprehensive income.
See Notes 3, 14 and 16(b) for further information regarding investments.
Premiums are recognized as revenue on a pro-rata basis over the term of an insurance policy. This recognition method is based on the short term (twelve months or less) nature of the lines of business written by AIHL’s insurance operating units, which consist of property and casualty and surety lines. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of insurance policies in force. Ceded premiums are charged to income over the applicable terms of the various reinsurance contracts with third-party reinsurers.
recoverables), based upon a number of factors. Such factors include the amounts outstanding, length of collection periods, disputes, any collateral or letters of credit held by AIHL’s insurance operating units and other relevant factors. Amounts deemed to be uncollectible are written off against the allowance for estimated uncollectible reinsurance recoverables. As of December 31, 2011 and December 31, 2010, Alleghany did not record an allowance for estimated uncollectible reinsurance recoverables.
Deferred acquisition costs are periodically reviewed to determine their recoverability from future income, including investment income, and if any such costs are determined to be not recoverable they are charged to expense.
Revenue and profits from land sales are recognized using the full accrual method when title has passed to the buyer, the collectibility of the sales price is reasonably assured, the required minimum cash down payment has been received and Alleghany has no continuing involvement with the property.
Basic earnings per share of common stock are based on the average number of shares of common stock, par value $1.00 per share, of Alleghany (“Common Stock”) outstanding during the years ended December 31, 2011, 2010 and 2009, respectively, retroactively adjusted for stock dividends. Diluted earnings per share of Common Stock are based on those shares used to calculate basic earnings per share of Common Stock. Diluted earnings per share of Common Stock also include the dilutive effect of stock-based compensation awards, retroactively adjusted for stock dividends. See Note 12.
In July 2010, the Financial Accounting Standards Board (“FASB”) issued guidance that provides for additional financial statement disclosure regarding financing receivables, including the credit quality and allowance for credit losses associated with such assets. This guidance is generally effective for interim and annual periods beginning after December 15, 2010, with certain disclosures effective for interim and annual periods ending on or after December 31, 2010. Alleghany fully adopted this guidance in the 2011 first quarter, and its implementation did not have any impact on its results of operations and financial condition.
In December 2011, the FASB issued guidance on disclosure requirements related to offsetting arrangements. This guidance provides for additional financial statement disclosure regarding offsetting and related arrangements to enable financial statement users to understand the effect of those arrangements on an entity’s financial position. This guidance is effective for interim and annual reporting periods beginning on or after January 1, 2013. Alleghany will adopt this guidance in the 2013 first quarter, and Alleghany does not currently believe that its implementation will have an impact on its results of operations and financial condition.
In September 2011, the FASB issued revised guidance on the testing of goodwill for impairment. This guidance simplifies how an entity tests goodwill for impairment by allowing an entity to first make a qualitative assessment to determine whether it is necessary to perform quantitative testing. Based on the results of such assessment, an entity will no longer be required to perform quantitative testing if it is more likely than not that the fair value of a reporting unit is greater than its carrying value. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. Alleghany will adopt this guidance in the 2012 first quarter, and Alleghany does not currently believe that its implementation will have an impact on its results of operations and financial condition.
option to report other comprehensive income and its components in the statement of changes in equity, and does not change the items that must be reported in other comprehensive income. This guidance is generally effective for interim and annual periods beginning after December 15, 2011. Alleghany will adopt this guidance in the 2012 first quarter, and Alleghany does not currently believe that its implementation will have an impact on its presentation of its financial statements.
In October 2010, the FASB issued guidance that provides additional clarification for costs associated with acquiring or renewing insurance contracts. This guidance states that only incremental, direct costs associated with the successful acquisition of a new or renewal insurance contract may be capitalized as deferred acquisition costs. Furthermore, such costs: (i) must be essential to the contract transaction; (ii) would not have been incurred had the contract transaction not occurred; and (iii) must be related directly to the acquisition activities involving underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. Advertising costs should be included in deferred acquisition costs only if the capitalization criteria in separate “direct response” advertising guidance within GAAP are met. All other acquisition-related costs and other expenses should be charged to expense as incurred. This guidance is effective for interim and annual periods beginning after December 15, 2011, with early adoption permitted (but only at the beginning of an entity’s annual reporting period). Alleghany will adopt this guidance prospectively in the 2012 first quarter, and Alleghany does not currently believe that its implementation will have a material impact on its results of operations and financial condition.
Transatlantic is a leading international reinsurance organization headquartered in New York, with operations on six continents. Its subsidiaries, Transatlantic Reinsurance Company, Trans Re Zurich Reinsurance Company Ltd. and Putnam Reinsurance Company, offer reinsurance capacity on both a treaty and facultative basis - structuring programs for a full range of property and casualty products, with an emphasis on specialty risks.
In the merger, each outstanding stock option to acquire Transatlantic common stock will be canceled in exchange for the right to receive a cash payment based on the Black-Scholes value of the outstanding stock options on the closing date. Outstanding Transatlantic restricted stock unit awards will be converted into a cash award based on the per share amount with the same terms and conditions as the related Transatlantic restricted stock unit award, that will either be (i) deemed notionally invested in the equity of the surviving company, (ii) with respect to continuing directors, deemed notionally invested in Common Stock, or (iii) maintained in a cash account and continue to vest on the existing vesting schedule.
On February 6, 2012, Alleghany stockholders approved the issuance of Common Stock in connection with the merger and Transatlantic approved the merger and certain related matters. The merger is subject to certain customary conditions, including, listing of the shares of Common Stock to be issued in the merger on the New York Stock Exchange and receipt of required regulatory approvals. Alleghany expects that the merger will close in the first quarter of 2012.
Both Alleghany and Transatlantic may terminate the merger agreement under certain specified circumstances. If the merger agreement is terminated due to certain breaches of the merger agreement by a party, that party may be required to reimburse the other party up to $35 million.
Available-for-sale securities as of December 31, 2011 and 2010 are summarized as follows (in millions):
(2) Of the $860.5 million of fair value as of December 31, 2011, $497.3 million related to residential mortgage-backed securities, or “RMBS,” $144.7 million related to commercial mortgage-backed securities, or “CMBS” and $218.5 million related to other asset-backed securities. Of the $866.5 million of fair value as of December 31, 2010, $499.9 million related to RMBS, $173.4 million related to CMBS and $193.2 million related to other asset-backed securities.
The proceeds from sales of available-for-sale securities were $1.9 billion, $1.5 billion and $1.7 billion, in 2011, 2010 and 2009, respectively. The amount of gross realized capital gains and gross realized capital losses of available-for-sale securities (primarily equity securities) for 2011, 2010 and 2009 were (in millions):
Alleghany holds its equity and debt securities as available-for-sale, and as such, these securities are recorded at fair value. Alleghany continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. If a decline in the value of a particular investment is deemed temporary, Alleghany records the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, Alleghany writes its cost-basis down to the fair value of the investment and records an other-than-temporary impairment loss on its statement of earnings, regardless of whether Alleghany continues to hold the applicable security. In addition, under GAAP, any portion of such decline that relates to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income.
(iii) it is more likely than not that Alleghany will sell a debt security before recovery of its amortized cost basis.
Alleghany then evaluates all remaining equity securities that are in an unrealized loss position the cost of which:
This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other-than-temporarily impaired including:
(ii) current views on the equity security, as expressed by either Alleghany’s internal stock analysts and/or by independent stock analysts or rating agencies; and
As of December 31, 2011, non-income producing invested assets were insignificant.
Homesite losses in 2011 primarily reflect the impact of increased homeowners insurance claims from severe weather, particularly tornados, in the southeastern and midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the east coast of the U.S. in August 2011. Homesite losses in 2011 also reflect a tax valuation adjustment. Homesite losses in 2010 and 2009 primarily reflect the impact of increased homeowners insurance claims from severe weather and ongoing purchase accounting adjustments.
The $21.9 million of losses in 2009 for ORX were due primarily to asset impairment charges incurred as of December 31, 2008, but finalized in the 2009 third quarter, arising from relatively low energy prices as of December 31, 2008.
On July 18, 2007 (the “Acquisition Date”), AIHL completed its acquisition of PCC for a purchase price of $198.1 million, including $5.6 million of incurred acquisition costs. PCC is included as an insurance operating unit within AIHL for segment reporting purposes.
The amount of goodwill and intangible assets, net of accumulated amortization expense, reported on Alleghany’s consolidated balance sheets as of December 31, 2011 and 2010 is as follows (in millions):
The economic useful lives of intangible assets are as follows: agency relationships - 15 years; state insurance licenses - indefinite; trade names - indefinite; brokerage and reinsurance relationships - 15 years and renewal and distribution rights - between 5 and 10 years.
AIHL’s insurance operating units would remain liable to their policyholders for such reinsurance portion not paid by their reinsurers.
RSUI. In 2011, RSUI ceded 36.4 percent of its gross premiums written to reinsurers. Although the net amount of loss exposure retained by RSUI varies by line of business, in general, as of December 31, 2011, RSUI retained a maximum net exposure for any single property risk of $19 million and any single casualty risk of $10.0 million, with the exception of losses arising from acts of foreign terrorism.
RSUI reinsures its other lines of business through quota share treaties, except for professional liability, binding authority and (effective April 15, 2011) the general liability lines where RSUI retains all of such business. RSUI’s quota share reinsurance treaty for umbrella/excess lines of business renewed on June 1, 2011 on the same terms as the expiring treaty, providing coverage for policies with limits up to $30.0 million, with RSUI ceding 35.0 percent of the premium and loss for policies with limits up to $15.0 million and ceding 67.5 percent of the premium and loss for policies with limits in excess of $15.0 million up to $30.0 million. RSUI’s D&O quota share reinsurance treaty renewed on July 1, 2011 on the same terms as the expiring treaty, providing coverage for policies with limits up to $20.0 million, with RSUI ceding 35.0 percent of the premium and loss for policies with limits up to $10.0 million and ceding 60.0 percent of the premium and loss for policies with limits in excess of $10.0 million up to $20.0 million.
Information regarding concentration of AIHL’s reinsurance recoverables as of December 31, 2011 is as follows (dollars in millions):
(1) Reinsurance recoverables reflect amounts due from one or more reinsurance subsidiaries of the listed company.
Ceded loss recoveries for AIHL included in Alleghany’s consolidated statements of earnings were $140.1 million, $119.4 million and $197.1 million as of December 31, 2011, 2010 and 2009, respectively.
Landmark. On September 2, 2003, RIC acquired Landmark from Guaranty National Insurance Company (“Guaranty National”) pursuant to a Stock Purchase Agreement dated as of June 6, 2003. In contemplation of the sale of Landmark to RIC, Landmark and Royal Indemnity Company, an affiliate of Guaranty National (“Royal Indemnity”), entered into a 100 percent Quota Share Reinsurance Agreement and an Assumption of Liabilities Agreement, each dated as of September 2, 2003. Pursuant to these two agreements, Royal Indemnity assumed all of Landmark’s liabilities of any nature arising out of or relating to all policies, binders, and contracts of insurance issued in Landmark’s name prior to the closing under the Stock Purchase Agreement, and all other liabilities of Landmark. The reinsurance recoverable and loss reserve liability recorded was $2.1 million, $2.4 million and $5.4 million as of December 31, 2011, 2010 and 2009, respectively.
The following table indicates property and casualty premiums written and earned for the years ended December 31, 2011, 2010 and 2009 (in millions):
Activity in liability for loss and LAE in 2011, 2010 and 2009 is summarized as follows (in millions):
* Reinsurance recoverables in this table include only ceded loss reserves.
The above reserve changes included (decreases) increases prior year net reserves, which are summarized as follows (in millions):
For RSUI, loss and LAE for 2011 and 2010 also include a net $3.3 million and $9.3 million release of prior accident year loss reserves, respectively, primarily related to a re-estimation of case and IBNR reserves in the property line of business. For 2011, the net $3.3 million reserve release primarily reflects significant net reserve releases in non-catastrophe property reserves and unallocated LAE, partially offset by reserve increases related to prior year catastrophes. For 2010, the net $9.3 million reserve release primarily reflects significant net reserve releases in non-catastrophe property reserves,
For CATA, loss and LAE for 2010 reflect a $3.5 million reserve release reflecting favorable loss emergence for asbestos and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976, based on a reserve study that was completed in the 2010 second quarter.
For PCC, loss and LAE for 2011 reflect a $28.4 million increase of prior accident year workers’ compensation net loss reserves, compared with a $12.5 million reserve increase of prior accident year workers’ compensation loss reserves during 2010. Of the $28.4 million increase, $15.0 million was recorded in the 2011 second quarter and $13.4 million was recorded in the 2011 fourth quarter, as follows (in millions):
PCC’s adverse claims emergence relates to an unanticipated increase in medical claims emergence and an absence of anticipated favorable indemnity claims emergence. PCC had anticipated favorable indemnity claims emergence based upon prior claims development experience which indicated that injured workers would be returning to work, curtailing lost wage costs. PCC believes the weak California employment environment has hindered the ability of injured workers to return to work and indirectly influenced indemnity claims. The increases in allocated and unallocated LAE reserves primarily reflect increased use of outside counsel to assist in the settlement process and higher litigation costs caused by recent Workers’ Compensation Appeals Board decisions. The decrease in ceded loss and LAE reserves was based on a second quarter 2011 review of reinsurance coverage estimates, which also resulted in a $1.1 million decrease in ceded premiums earned, thereby increasing net premiums earned in the 2011 second quarter.
For PCC, the $12.5 million increase in loss and LAE for 2010 relates primarily to a decrease in ceded loss and LAE reserves based on a fourth quarter 2010 review of reinsurance coverage estimates and, to a lesser extent, an increase in unallocated LAE reserves, which also resulted in a $5.0 million decrease in ceded premiums earned, thereby increasing net premiums earned in 2010.
On September 20, 2010, Alleghany issued $300.0 million of 5.625% Senior Notes due on September 15, 2020 (“Senior Notes”). The 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 Senior Notes permit redemption prior to their maturity. The indenture under which the Senior Notes were issued contains covenants that impose conditions on Alleghany’s ability to create liens on the capital stock of AIHL or RSUI or to engage in sales of the capital stock of AIHL or RSUI. The Senior Notes were issued at a discount of approximately 99.63 percent, resulting in proceeds before 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 Senior Notes.
The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement requires Alleghany to, among other things, (i) maintain a consolidated net worth of not less than the sum of (x) approximately $2.0 billion plus (y) 50 percent of Alleghany’s accumulated, consolidated net earnings earned in each fiscal quarter (if positive) commencing September 30, 2010 and (ii) maintain a ratio of total indebtedness to total capital as of the end of each fiscal quarter of not greater than 0.25 to 1.0. Additionally, the Credit Agreement contains various negative covenants with which Alleghany 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; and other provisions customary in similar types of agreements. There were no borrowings under the Credit Agreement during 2010 or 2011.
As of December 31, 2011, Alleghany had stock-based payment plans for parent-level employees and directors. As described in more detail below, parent-level, stock-based payments to current employees do not include stock options but consist only of restricted stock awards, including restricted stock units and performance share awards. Parent-level, stock-based payments to non-employee directors consist of annual awards of stock options and restricted stock, including restricted stock units. In addition, as of December 31, 2011, RSUI and PCC had their own stock-based payment plans, which are described below.
Alleghany’s 2005 Directors’ Stock Plan, which expired on December 31, 2009, provided for the automatic grant of nonqualified options to purchase 500 shares of Common Stock, as well as an automatic grant of 250 shares of restricted Common Stock or, under certain circumstances, restricted stock units, to each non-employee director on an annual basis. In 2010, Alleghany established the 2010 Directors’ Stock Plan which provides for the same automatic grants to directors as the 2005 Directors’ Stock Plan. In 2011 and 2010, Alleghany awarded a total of 2,500 restricted shares and units, which vest over a one year period.
A summary of option activity under the above plans as of December 31, 2011 and changes during the year then ended is presented below:
A summary of the status of Alleghany’s non-vested shares as of December 31, 2011, and changes during the year ended December 31, 2011, is presented below:
As of December 31, 2011, there was $0.8 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the 2005 and 2010 Directors’ Stock Plans. That cost is expected to be recognized over a weighted-average period of approximately one year. The total fair value of shares vested during the years ended December 31, 2011, 2010 and 2009, was $1.3 million, $1.6 million and $1.1 million, respectively.
(i) Performance Share Awards - Participants are entitled, at the end of a four-year award period, to a maximum amount equal to the value of one and one-half shares of Common Stock for each performance share issued to them based on market value on the payment date. Payouts are made provided defined levels of performance are achieved. Prior to 2009, awards were generally made in cash to the extent of minimum statutory withholding requirements in respect of an award, with the balance in Common Stock. Expense was recognized over the performance period on a pro rata basis. In 2009, Alleghany modified its payout policy to allow participants to elect the percentage of performance shares to be paid in cash, subject to certain limitations. As a result, the accounting for all awards was changed pursuant to GAAP, whereby the fair value of each award outstanding is recorded, with changes therefrom recorded as an expense. The fair value is calculated based primarily on: the value of Common Stock as of the balance sheet date; the degree to which performance targets specified in the 2002 LTIP and 2007 LTIP have been achieved; and the time elapsed with respect to each award period. The resulting change in accounting in the fourth quarter of 2009 reduced Alleghany’s net earnings by $3.0 million after-tax.
During 2010, PCC granted non-qualified stock options (the “Options”) to two senior PCC executives. The Options vest over two years and expire in five years. Under the terms of the grants, the executives may purchase from AIHL common stock of PCC representing an aggregate of approximately 5 percent of PCC common stock outstanding, at a price based on grant-date book value of PCC. Once the Options are exercised, the PCC common stock held by each executive may be converted to cash at either AIHL’s election or the executive’s election, based on PCC’s book value. The compensation expense recorded by PCC in 2011 and 2010 was immaterial.
The following tables set forth both defined benefit plans’ funded status as of December 31, 2011 and 2010 and total cost for the years ended December 31, 2011, 2010 and 2009 (in millions, except percentages):
Alleghany leases certain facilities, furniture and equipment under long-term lease agreements. In addition, certain land, office space and equipment are leased under noncancelable operating leases that expire at various dates through 2020. Rent expense was $10.5 million, $10.5 million and $10.7 million in 2011, 2010 and 2009, respectively. The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2011 were as follows (in millions):
AIHL’s reserve for unpaid loss and LAE includes $13.7 million of gross reserves and net reserves as of December 31, 2011, and $14.1 million of gross reserves and $14.0 million of net reserves as of December 31,
2010, for asbestos and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976. This subsidiary exited this business in 1976. CATA released $3.5 million of such net reserves at June 30, 2010 based on a reserve study that was completed in the 2010 second quarter. Reserves for asbestos and environmental impairment claims cannot be estimated with traditional loss reserving techniques because of uncertainties that are greater than those associated with other types of claims. Factors contributing to those uncertainties include a lack of historical data, the significant periods of time that often elapse between the occurrence of an insured loss and the reporting of that loss to the ceding company and the reinsurer, uncertainty as to the number and identity of insured parties with potential exposure to such risks, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Loss reserve estimates for such environmental impairment and asbestos exposures include case reserves, which also reflect reserves for legal and other LAE and IBNR reserves. IBNR reserves are determined based upon historic general liability exposure base and policy language, previous environmental loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law, and judicial settlements of asbestos liabilities.
As of December 31, 2011 and 2010, Alleghany had a concentration of market risk in its available-for-sale equity securities portfolio with respect to certain energy sector businesses of $573.3 million and $1,004.8 million, respectively. Of the $573.3 million, $254.3 million represented Alleghany’s ownership of common stock of Exxon Mobil Corporation. Alleghany subsequently sold all of its holdings in Exxon Mobil Corporation in January of 2012, and Alleghany will record a pre-tax gain of $63.1 million in the first quarter of 2012.
The estimated carrying values and fair values of Alleghany’s consolidated financial instruments as of December 31, 2011 and December 31, 2010 were as follows (in millions):
GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, GAAP has a three-tiered hierarchy for inputs 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. For example, Alleghany may consider a market 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, and as such, little or no weight is given to that transaction as an indicator of fair value.
(1) RSUI’s 2011 net premiums earned includes immaterial amounts arising from reinsurance assumed from insurance companies domiciled outside the U.S. (specifically, in France and the United Kingdom).
(4) For 2011, primarily reflects net realized capital gains from the sale of shares of common stock of Exxon Mobil Corporation. For 2009, primarily reflects net realized capital gains from the sale of shares of Burlington Northern common stock.
(6) Represents net premiums earned less loss and LAE and commission, brokerage and other underwriting expenses, all as determined in accordance with GAAP, does not include net investment income, net realized capital gains, other-than-temporary impairment losses, other income or other expenses. Commissions, brokerage and other underwriting expenses represent commission and brokerage expenses and that portion of salaries, administration and other operating expenses attributable primarily to underwriting activities, whereas the remainder constitutes other expenses.
Other assets shown in Alleghany’s consolidated balance sheets include the following amounts as of December 31, 2011 and 2010 (in millions):
Other invested assets shown in Alleghany’s consolidated balance sheets include the following amounts as of December 31, 2011 and 2010 (in millions):
* Equity method partnership investments were dissolved during the third quarter of 2010, and thus were not outstanding as of December 31, 2010 and December 31, 2011.
Property and equipment, net of accumulated depreciation and amortization, as of December 31, 2011 and 2010, were as follows (in millions):
Activity in deferred acquisition cost assets as shown in Alleghany’s consolidated balance sheets in 2011 and 2010 is summarized as follows (in millions):
Other liabilities shown in Alleghany’s consolidated balance sheets include the following amounts as of December 31, 2011 and 2010 (in millions):
Earnings per share by quarter may not equal the amount for the full year due to the timing of repurchases of Common Stock and rounding.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alleghany Corporation and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
In our opinion, Alleghany Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
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, 2011 and 2010, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011, and our report dated February 22, 2012 expressed an unqualified opinion on those consolidated financial statements.