We lease office space in Bermuda, where our principal executive offices are located. Argo Group US leases office space in San Antonio, Texas, for its United States headquarters, Commercial Specialty segment and for certain support functions. We also lease space in the following locations:
In addition, we have entered into other leases in conjunction with our operations at various geographic locations throughout the world. The properties are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. We believe the facilities we occupy are adequate for the purposes in which they are currently used and are well maintained.
The following is a comparison of selected data from our operations:
Consolidated net investment income decreased for the year ended December 31, 2013 as compared to the same periods ended 2012 and 2011 due primarily to the continued reinvestment at market yields below the portfolio’s book yield, a shift in strategy towards slightly shorter duration investments and a movement of a portion of the portfolio out of traditional fixed income investments. Total invested assets at December 31, 2013 were $3,991.9 million, net of $87.3 million of invested assets attributable to Argo International’s trade capital providers. Total invested assets at December 31, 2012 were $4,056.8 million, net of $143.9 million of invested assets attributable to such trade capital providers. Total invested assets at December 31, 2011 were $3,985.0 million, net of $162.5 million of invested assets attributable to such trade capital providers. The decline in total invested assets was primarily attributable to the transfer of assets as a result of our entering into a whole account quota share contract within our Syndicate 1200 segment.
Consolidated gross realized gains were $131.6 million for the year ended December 31, 2013, as compared to $54.4 million and $74.2 million in 2012 and 2011, respectively. The increase in the gross realized gains for the year ended December 31, 2013 was primarily attributable to $59.1 million in realized gains, from a target reduction in certain equity holdings. Consolidated gross realized losses were $60.3 million, $28.7 million and $25.0 million for the years ended December 31, 2013, 2012 and 2011, respectively. Included in gross realized losses for the year ended December 31, 2013 were $19.6 million and $30.8 million of losses on our fixed maturity and other invested assets portfolios, respectively, as we reduced our non-investment grade holdings. Included in consolidated gross realized losses for the years ended December 31, 2013, 2012 and 2011 were write downs of approximately $7.8 million, $3.7 million and $1.2 million, respectively, from the recognition of other-than-temporary impairments on certain investment securities.
Consolidated losses and loss adjustment expenses were $742.0 million for the year ended December 31, 2013, compared to $747.6 million and $863.1 million for the same periods in 2012 and 2011, respectively. Included in losses and loss adjustment expense was $24.6 million in catastrophe losses primarily attributable to storm activity in the United States and Germany and to flooding in Europe and Canada. Included in losses and loss adjustment expense for the year ended December 31, 2013 were current accident year large losses of $16.8 million in our Excess and Surplus Lines, Commercial Specialty and International Specialty segments. Offsetting these 2013 accident year losses was $33.6 million in net favorable loss reserve development on prior accident years, primarily within our general liability lines of business.
Consolidated gross reserves for loss and loss adjustment expense were $3,230.3 million (including $128.6 million of reserves attributable to Argo International’s trade capital providers), $3,223.5 million (including $161.6 million of reserves attributable to the trade capital providers) and $3,291.1 million (including $196.6 million of reserves attributable to the trade capital providers) as of December 31, 2013, 2012 and 2011, respectively. Management has recorded its best estimate of loss reserves at each date based on current known facts and circumstances. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development, favorable or unfavorable, will not occur.
The following table summarizes the results of operations for the Excess and Surplus Lines segment:
Included in losses and loss adjustment expenses for the year ended December 31, 2012 was $12.6 million in catastrophe losses from storm activity in the United States, including $8.2 million from Hurricane Isaac and $2.6 million from Superstorm Sandy. Offsetting these catastrophe losses was $48.0 million of net favorable loss reserve development on prior accident years primarily attributable to $39.2 million of favorable development in the general and products liability lines of business.
Included in losses and loss adjustment expenses for the year ended December 31, 2011 was $7.6 million in catastrophe losses from storm activity in the United States, including the Alabama and Joplin, Missouri tornados and Hurricane Irene. Offsetting these catastrophe losses was $33.8 million of net favorable loss reserve development on prior accident years primarily resulting from $30.2 million of favorable development in the general and products liability lines of business.
The decline in the expense ratio for the year ended December 31, 2013 as compared to 2012 and 2011 was primarily attributable to a shift of select functions from risk bearing activities to non risk-bearing activities, as we began to develop our fee-based business. The increase in the expense ratio for the years ended December 31, 2012 as compared to the same period in 2011 was primarily attributable to the reductions in earned premiums outpacing the reductions in total underwriting expenses.
As noted above, in 2013 we began to focus on the development of our fee-based operations. As a result, the expenses associated with the fee-based operations have outpaced the income received for these activities, resulting in net fee expense for the year ended December 31, 2013.
Gross written and earned premiums increased for the year ended December 31, 2013 in comparison to the same periods in 2012 and 2011 primarily as a result of continued growth in our Brazil operations and in our excess casualty and professional lines units, while gross written premiums for the property reinsurance lines remained consistent. Gross written premiums for the property reinsurance lines were $134.0 million, $132.6 million and $133.8 million for the years ended December 31, 2013, 2012 and 2011, respectively. Gross written premiums for the excess casualty and professional lines unit were $91.0 million, $80.8 million and $64.4 million for the years ended December 31, 2013, 2012 and 2011, respectively. Gross written premiums for our Brazil operations, which began writing premiums in 2012, were $65.6 million and $46.8 million for the years ended December 31, 2013 and 2012, respectively.
Losses and loss adjustment expenses for the year ended December 31, 2012 included $24.7 million in catastrophe losses from storm activity in the United States, including $23.6 million from Superstorm Sandy. In addition, International Specialty experienced $6.0 million in losses related to crop exposures. Partially offsetting these current accident year losses was $7.2 million of net favorable loss reserve development on prior accident years primarily attributable to $7.4 million of favorable development in short-tail non-catastrophe losses.
Losses and loss adjustment expenses for the year ended December 31, 2011 included $118.1 million in catastrophe losses including $75.3 million resulting from the Japan and New Zealand earthquakes, $24.9 million from the Thailand and Australia floods and the Danish cloudburst and $17.9 million from storms in the United States including the Alabama and Joplin, Missouri tornados and Hurricane Irene and aggregate reinsurance covers losses of $9.3 million. Partially offsetting these 2011 accident year losses was $4.6 million of net favorable reserve development on prior accident year’s loss reserves, primarily from $7.0 million attributable to short-tail non-catastrophe losses offset by $2.5 million of unfavorable development in long-tail lines primarily due to the 2010 Deepwater Horizon incident.
The increase in earned premiums in 2013 as compared to 2012 and 2011 is primarily attributable to the increase in gross written premiums discussed above.
Earned premiums for the years ended December 31, 2013, 2012 and 2011 were primarily attributable to adjustments resulting from final audits, reinstatement premiums and other adjustments on policies previously written.
Underwriting, acquisition and insurance expenses for the Run-off Lines segment consists primarily of administrative expenses. Underwriting expense for the year ended December 31, 2012 were reduced $2.6 million due to a reduction in insurance assessments. Bad debt expense, net of recoveries, on uncollectible reinsurance recoverable balances of $3.4 million was included for the year ended December 31, 2011. Absent these items, underwriting expenses were comparable for the years presented.
The following table represents a reconciliation of total gross and net reserves for the Run-off Lines for each of the years in the three-year period ended December 31, 2013. Amounts in the net column are reduced by reinsurance recoverables.
The following table represents the components of gross loss reserves for the Run-off Lines for each of the years in the three-year period ended December 31:
We perform an extensive actuarial analysis of the asbestos and environmental reserves on at least an annual basis. We continually monitor the status of the claims, and may make adjustments outside of the annual review period. The review entails a detailed analysis of our direct and assumed exposure. Management considers the indications from the various actuarial methods from that
review to determine their best estimate of the asbestos and environmental losses and loss adjustment expense reserves. Management primarily relied on a method that projects future reported claims and severities, with some weight given to other methods. This method relies most heavily on our historical claims and severity information, whereas other methods rely more heavily on industry information. The method produces an estimate of losses that have been incurred but not yet reported based on projections of future claims and the average severity for those future claims. The severities were calculated based on our specific data and in management’s opinion best reflect our liabilities based upon the insurance policies issued.
The following table represents a reconciliation of the number of asbestos and environmental claims outstanding for each of the years in the three-year period ended December 31, 2013:
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2013:
Because of the types of coverages within the Run-off Lines of business still being serviced by Argonaut Insurance Company, a significant amount of subjectivity and uncertainty exists in establishing the reserves for losses and loss adjustment expenses. Factors that increase these uncertainties are: (1) lack of historical data, (2) inapplicability of standard actuarial projection techniques, (3) uncertainties regarding ultimate claim costs, (4) coverage interpretations and (5) the judicial, statutory and regulatory environments under which these claims may ultimately be resolved. Significant uncertainty remains as to our ultimate liability due to the potentially long waiting period between exposure and emergence of any bodily injury or property damage and the resulting potential for involvement of multiple policy periods for individual claims. Due to these uncertainties, the current trends may not be indicative of future results. Although management has determined and recorded its best estimate of the reserves for losses and loss adjustment expenses for Run-off Lines, current judicial and legislative decisions continue to broaden liability, expand policy scopes and increase the severity of claims payments. As a result of these and other recent developments, the uncertainties inherent in estimating ultimate loss reserves are heightened, further complicating the already complex process of determining loss reserves. The industry as a whole is involved in extensive litigation over these coverages and liability issues, and must contend with the continuing uncertainty in its effort to quantify these exposures.
The primary sources of cash flow for Argo Group and its subsidiaries are premiums, reinsurance recoveries, proceeds from sales and redemptions of investments and investment income. The primary cash outflows are claim payments, loss adjustment expenses, reinsurance costs and operating expenses. The nature of insurance is that cash collected for premiums written is invested, interest and dividends are earned thereon and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of our losses and loss expenses are paid out after more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payroll and general overhead expenses. Management believes that cash receipts from premiums, proceeds from investment sales and redemptions and investment income are sufficient to cover cash outflows in the foreseeable future. Should the need for additional cash arise, we believe we have access to additional sources of liquidity.
and cash used by operating activities of $17.7 million for the year ended December 31, 2011. The decrease in cash flows from operations in 2013 compared to 2012 was primarily due to net cash payment of $86.2 million in partial settlement of a whole account quota share contract covering the Syndicate 1200 segment loss reserves for the 2009 and prior years of account. The source of cash used to settle this reinsurance payable was the sale of fixed maturity assets, and is included in the cash from investing activities of our Statements of Cash Flow. The increase in cash flows from operations in 2012 compared to 2011 was primarily attributable to increased collections on our reinsurance recoverables on paid losses and a decrease in claim payments.
For the year ended December 31, 2013, net cash provided by investing activities was $120.8 million compared to net cash used by investing activities of $3.7 million for the year ended December 31, 2012 and cash provided by investing activities of $102.1 million for the year ended December 31, 2011. The increase in cash flows from investing activities from 2012 to 2013 was mainly the result of the sale of fixed maturity assets used to settle Syndicate 1200 reinsurance payable. The decrease in cash flows from investing activities in 2012 compared to 2011 was primarily a result of fewer sales of investments as the positive inflow of cash from operations combined with the excess of the proceeds from the issuance of the senior unsecured fixed rate notes assisted in meeting operational activities. As of December 31, 2013, 2012 and 2011, $351.6 million, $234.3 million and $294.6 million, respectively, of the investment portfolio were invested in short-term investments.
For the years ended December 31, 2013, 2012 and 2011, net cash used by financing activities was $59.5 million, $33.8 million and $61.6 million, respectively. During 2013, our use of cash was primarily attributed to the repurchase of approximately 1.1 million shares of our common stock for a total cost of $46.5 million and the payment of dividends to our shareholders totaling $15.8 million. During 2012, our use of cash was attributed to $117.2 million for the redemption of our two fixed rate trust preferred securities, the repurchase of approximately 1.5 million shares of our common stock for a total cost of $44.2 million and the payment of dividends to our shareholders totaling $12.3 million. In 2012, the use of cash was offset by $138.7 million in net cash proceeds from the issuance of senior unsecured fixed rate notes. During 2011, our use of cash was primarily attributed to the repurchase of approximately 1.6 million shares of our common stock for a total cost of $49.5 million, and the payment of dividends to our shareholders totaling $13.1 million.
For the year ended December 31, 2013, Argo Re paid a cash dividend of $84.5 million to Argo Group which was used to repay an intercompany note. For the year ended December 31, 2013, Argo Group US received dividends of $76.2 million from Colony, $24.8 million from Argonaut Insurance Company and $9.5 million from Rockwood.
The payment of dividends by Argo Re is limited under Bermuda insurance laws, which require Argo Re to maintain certain measures of solvency and liquidity. As of December 31, 2013, the unaudited statutory capital and surplus of Argo Re was estimated to be $1,218.2 million and the amount required to be maintained was estimated to be $343.9 million, thereby allowing Argo Re the potential to pay dividends or capital distributions within the parameters of the solvency and liquidity margins. We believe that the dividend and capital distribution capacity of Argo Re will provide us with sufficient liquidity to meet the operating and debt service commitments, as well as other obligations.
During 2014, Argo Group US may be permitted to receive dividends from its subsidiaries as follows: Colony - $41.5 million, Argonaut Insurance Company - $24.8 million and Rockwood -$18.1 million. Business and regulatory considerations may impact the amount of dividends actually paid, and prior approval of dividend payments may be required.
On April 30, 2010, each of Argo Group International Holdings, Ltd., Argo Group US, Argo International Holdings Limited, and Argo Underwriting Agency Limited (the “Borrowers”) entered into a $150,000,000 Credit Agreement (“Credit Agreement”) with a syndicate of commercial banks. On July 22, 2011, the Borrowers entered into Amendment No. 2 to the Credit Agreement, which increased the revolving credit facility under the Credit Agreement from $150.0 million to $170.0 million, extended the maturity date from April 30, 2013 to April 30, 2014, and modified certain other terms. Borrowings under the Credit Agreement may be used for general corporate purposes, including working capital and permitted acquisitions, and each of the Borrowers has agreed to be jointly and severally liable for the obligations of the other Borrowers under the Credit Agreement. The Credit Agreement contains customary events of default. If an event of default occurs and is continuing, the Borrowers could be required to repay all amounts outstanding under the Credit Agreement. Lenders holding more than 51% of the loans and commitments under the Credit Agreement may elect to accelerate the maturity of the loans under the Credit Agreement upon the occurrence and during the continuation of an event of default. No defaults or events of defaults have occurred as of the date of this filing. Currently, we do not have any amounts due under the $170.0 million credit facility. The credit facility allows up to $15.0 million of the facility to be used for letters of credit (“LOCs”) subject to availability under the line. Currently, we have $0.2 million in LOCs issued and outstanding under the credit facility.
We have two additional LOC facilities totaling $500.0 million that allow us to provide LOCs to our ceding companies if such LOC is required under the terms of the contract and to Lloyd’s to be filed on behalf of Argo (No. 604) Limited, our corporate member at Lloyd’s. All of the facilities require us to provide collateral in the form of fixed maturity securities or cash to the issuing bank as security for the outstanding LOCs. We also have a previously issued facility that has since been canceled under which we still have outstanding LOCs. We no longer have the ability to issue new LOCs from this facility. We must transfer eligible assets to collateral accounts prior to each respective bank issuing an LOC. Since eligible assets include fixed maturity investments, such securities need not be sold in order to qualify as eligible collateral. At December 31, 2013, we have pledged assets with a fair value of $98.6 million to support outstanding LOCs.
Under certain insurance programs (i.e., large deductible programs and surety bonds) and various reinsurance agreements, collateral and letters of credit are held for our benefit to secure performance of insureds and reinsurers in meeting their obligations. At December 31, 2013, the amount of such collateral and LOCs held under insurance and reinsurance agreements were $861.1 million and $335.5 million, respectively. Collateral can be provided in the form of trust accounts. As we are the beneficiary of these trust accounts only to secure future performance, these amounts are not reflected in our Consolidated Balance Sheets. Collateral provided by an insured or reinsurer may exceed or fall below their total outstanding obligation.
In September 2012, through our wholly owned subsidiary Argo Group US, we issued $143,750,000 aggregate principal amount of Argo Group US’s 6.5% Senior Notes due September 15, 2042 (the “Notes”). The Notes bear interest at 6.5%, payable quarterly in cash in arrears on the 15th day of March, June, September and December of each year, beginning on December 15, 2012.
The Notes are unsecured and unsubordinated obligations of Argo Group US and rank equally in right of payment with all of Argo Group US’s other unsecured and unsubordinated debt. The Notes are guaranteed on a full and unconditional senior unsecured basis by Argo Group. The Notes may be redeemed, for cash, in whole or in part, on or after September 15, 2017, at Argo Group US’s option, at any time and from time to time, prior to maturity at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued but unpaid interest on the principal amount being redeemed to, but not including, the redemption date. The proceeds, net of issuance costs, from the sale of the Notes were $138.7 million and were used to repay $118.6 million of principal related to two of our trust preferred securities, with the remainder used for general corporate purposes.
On October 1, 2012, we gave notice of redemption to the trustee of our 8.85% PXRE Capital Trust I $103,093,000 Junior Subordinated Debt Securities (“Capital Trust I”). Capital Trust I was redeemed on November 13, 2012 at a redemption price equal to 102.090% of its principal amount, plus accrued and unpaid interest through the date of redemption. Additionally, on October 8, 2012, we gave notice of redemption to the trustee of our 9.75% PXRE Capital Trust III $15,464,000 Junior Subordinated Debt Securities (“Capital Trust III”). Capital Trust III was redeemed on November 23, 2012 at a redemption price equal to 100.975% of its principal amount, plus accrued and unpaid interest through the date of redemption. Interest on Capital Trust I and Capital Trust III ceased to accrue on and after the redemption dates. Subsequent to redemption, we received $3.1 million and $0.5 million for our ownership in Capital Trust I and Capital Trust III, respectively. Redemption of Capital Trust I and Capital Trust III resulted in recognition of expense for a call premium of $2.1 million and $0.1 million, respectively, shown in “Debt extinguishment costs” in our Consolidated Statement of Income (Loss) for the year ended December 31, 2012. Capital Trust I had an unamortized discount of $0.4 million that was charged off to “Interest expense” in our Consolidated Statement of Income (Loss) for the year ended December 31, 2012.
We assumed debt through the acquisition of Argo International. These notes are unsecured. All are redeemable subject to certain terms and conditions at a price up to 100% of the principal plus accrued and unpaid interest. Interest on the U.S. Dollar and Euro notes is due semiannually and quarterly, respectively. A summary of the notes outstanding at December 31, 2013 is presented below:
We invest excess cash in a variety of investment securities. As of December 31, 2013, our investment portfolio consisted of 69.0% fixed maturities, 13.1% equity securities, 9.3% other investments and 8.6% short-term investments (based on fair value) compared to 75.1% fixed maturities, 12.4% equity securities, 6.9% other investments and 5.6% short-term investments as of December 31, 2012. We classify the majority of our investment portfolio as available-for-sale; resulting in these investments being reported at fair market value, with unrealized gains and losses, net of tax, being reported as a component of shareholders’ equity. At December 31, 2013, no investments were designated as trading. No issuer (excluding United States Government and United States Governmental agencies) of fixed maturity or equity securities represents more than 3.6% of shareholders’ equity at December 31, 2013.
We control our credit exposure related to receivables by limiting exposure to any one counterparty and evaluating the financial strength of our reinsurance counterparties, including generally requiring minimum credit ratings.
In 2013, our Surety unit received a submission through its established broker network to issue approximately $13 million of surety bonds on behalf of Kinetica Partners, LLC (“Kinetica”) in connection with a Gulf of Mexico pipeline project. Mr. Gary Woods, Chairman of our Board of Directors, is the President of Kinetica, and beneficially owns 10% of Kinetica through a family trust. The submission was underwritten, priced and bound in the ordinary course of business by the Surety unit. The terms and conditions of the surety bonds that were issued and the premium charged to Kinetica for issuance of the bonds, were consistent with those routinely applied and charged for similarly situated risks bound for unrelated third parties. Per the Surety unit’s standard requirements in connection with the issuance of surety bonds, Kinetica and Mr. Woods, in his personal capacity, among others, executed our Surety unit’s standard form of indemnity agreement holding our Surety unit harmless against any and all losses and expenses incurred resulting from the issuance of the surety bonds.
(2) Interest only on Senior Unsecured Fixed Rate Notes through 2042. Interest calculated based on the rate in effect at December 31, 2013. Principal due September 2042.
(5) Contingent consideration for asset purchase is estimated at the maximum payout if profit targets are met.
(7) Multi-year reinsurance contract’s base terms, as reflected in the above table, include premium per annum of $26.5 million during the coverage period of January 1, 2014 to December 31, 2017. Based on the loss results of risks covered by the contract, additional annual premium installments ranging between $13 million and $39 million may be due beginning after December 31, 2014. The contract contains an early termination clause whereby we may terminate the contract at December 31, 2015 or December 31, 2016, subject to meeting certain contractual stipulations.
Reserves for Losses and Loss Adjustment Expenses. We establish reserves for the estimated total unpaid costs of losses including loss adjustment expenses (“LAE”), for losses that occurred in 2013 and prior. Unless otherwise specified below, the term “loss reserves” encompasses reserves for both losses and LAE. Loss reserves reflect management’s best estimate of the total cost of (i) claims that have been incurred, but not yet paid and (ii) claims that have been “incurred but not yet reported” (“IBNR”). Loss reserves established are not an exact calculation of our liability. Rather, loss reserves represent management’s best estimate of its liability based on application of actuarial techniques and other projection methodologies and taking into consideration other facts and circumstances known at the balance sheet date. The process of establishing loss reserves is complex and necessarily imprecise, as it involves using judgment that is impacted by many variables such as past loss experience, current claim trends and the prevailing social, economic and legal environments. The impact of both internal and
external variables on ultimate loss and LAE costs is difficult to estimate. We underwrite several different product lines across many different geographic regions with exposure impacted by both the risk characteristics of the physical locations such as wind perils, as well as risks associated with varying social, judicial and legislative characteristics of the jurisdictions in which we do business. In determining loss reserves, we give careful consideration to all available data and actuarial analyses and this process involves significant judgment.
The relevant factors and methodologies used to estimate loss reserves vary significantly by product line due to differences in loss exposure and claim complexity. Much of our business is underwritten on an occurrence basis, meaning that there may be a significant time lag between the event that gives rise to a claim and the date on which the claim is reported to us, which can also result in additional time being required to resolve the claim. During these time lags, which can span over several years for complex claims, new facts and information specific to the claim become known to us, and general econometric and societal trends including inflation continue to change, requiring us to refine our loss reserve estimates on a regular basis. We apply a strict regimen to assure that review of these facts and trends occurs on a timely basis so that this information can be factored into our estimate of future liabilities. However, due to the number and potential magnitude of these variables, actual paid losses in future periods may differ materially from our estimates as reflected in current reserves. These differences can be favorable or unfavorable. More precise estimation of loss reserves is also hindered by the effects of growth in a line of business and uncertainty as to how new business performs over time. In addition to reserving for known claim events, we also establish loss reserves for IBNR. Loss reserves for IBNR are set using our actuarial estimates for events that have occurred as of the balance sheet date but have yet to be reported to us. Estimation of IBNR loss reserves is subject to significant uncertainty.
When we initially establish IBNR reserves at the beginning of an accident year for each line of business, we use the expected loss ratio method. This method is based upon our analyses of historical loss ratios incorporating adjustments for pricing changes, anticipated loss ratio trends, changes in reinsurance structure and any other factors that may impact loss ratio expectations. At the end of each quarter, we review the loss ratio selections and the emerged loss experience to determine if deviating from the loss ratio method is appropriate. In general, we continue to use the loss ratio method until the end of the
Workers compensation is also a long-tail line of business. An expected loss ratio method is used for the initial evaluations of an accident year, followed by paid and incurred BF loss development methodologies as well as paid and incurred development methods as the data matures. Loss development for workers compensation spans many years. However, a significant portion of the outstanding reserves correspond to scheduled annuity payments and are not subject to extreme volatility. The portion of reserves that is not scheduled or annuitized is subject to potentially large variations in ultimate loss cost due to the uncertainty of medical cost inflation. Sources of medical cost inflation include increased utilization, new and more expensive medical testing procedures, and increased utilization and cost of prescription drugs.
We have a Run-off Lines segment that includes reserves for asbestos, environmental and other latent exposures. These latent exposures are typically characterized by extended periods of time between the date we first became exposed to a loss, the date on which a claim was reported and the date on which the claim is resolved. For our Run-off Lines segment long-tail loss reserves, there is significant uncertainty involved in estimating reserves for asbestos, environmental and other latent injury claims. We utilize several methods to estimate reserves for these claims including an approach that projects future calendar period claims and severities, a report year method which estimates loss reserves based on the pattern and magnitude of reported claims and ground-up analysis that relies on an evaluation of individual policy terms and conditions. We also consider survival ratio and market share methods which compare our level of loss reserves and loss payments to that of the industry for similar exposures. We apply greatest weight to the method that projects future calendar period claims and severities because we believe it best captures the unique claim reporting and claim severity characteristics of the underlying exposures and loss development potential. We perform a full review of our Run-off Lines asbestos, environmental and other latent exposures loss reserves at least once a year and review loss activity quarterly for significant changes that might impact management’s best estimate.
The major causes of uncertainty will vary for each product line reviewed. For short-tail property lines of business, we are exposed to catastrophe losses, both natural and manmade. Due to the nature of certain catastrophic loss events, such as hurricanes, earthquakes or terrorist attacks, our normal claims resolution processes may be impaired due to factors such as difficulty in accessing impacted areas and other physical, legal and regulatory impediments. These factors can make establishment of accurate loss reserve estimates difficult and render such estimates subject to greater uncertainty. Additionally, if the catastrophe occurs near the end of a financial reporting period, there are additional uncertainties in loss reserve estimates due to the lack of sufficient time to conduct a thorough analysis. Long-tail casualty lines of business also present challenges in establishing appropriate loss reserves, particularly in the event of changes in the legal environment over time which may broaden our liability or scope of policy coverage and increase the magnitude of claim payments. The possibility of future adverse changes in the legal environment heightens the uncertainty inherent in estimating the ultimate claim costs on the basis of past claims costs, further complicating the already complex loss reserving process.
In addition to the previously described general uncertainties encountered in estimating loss reserves, there are significant additional uncertainties in estimating the amount of our potential losses from asbestos and environmental claims. Loss reserves for asbestos and environmental claims cannot normally be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding these types of claims. Among the uncertainties impacting the estimation of such losses are:
difficulty in properly allocating responsibility and/or liability for environmental or asbestos damage;
historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of claims;
Many of our general liability claims require extended time periods to resolve due to delays in reporting, complex coverage issues and difficulties in assessing claim values and ultimate loss payouts. Some lines require specialized claim handling, such as industrial casualty, general casualty and professional liability exposures and require additional time to resolve. Actuarial methods used to forecast ultimate liabilities in these lines are adjusted to take into consideration the uncertainties related to handling claims expected to remain open for an extended period of time as well as the Claims and Book of Business risk factors noted above.
Workers compensation is generally considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. Certain payments, such as initial medical treatment or temporary wage replacement for the injured worker, are generally disbursed quickly. Other payments are made over the course of several years, such as awards for permanent partial injuries. Some payments continue to take place throughout the injured worker’s life, such as permanent disability benefits and on-going medical care. Although long-tail in nature, claims generally are not subject to long reporting lags, settlements are generally not complex and most of the liability exposure is characterized by high frequency and moderate severity. The largest reserve risks are generally associated with low frequency, high severity claims that require lifetime coverage for medical expense arising from a worker’s injury.
Examples of loss and LAE risk factors that can change over time and cause workers compensation loss reserves to fluctuate include, but are not limited to, the following:
Changes in the interpretations and processes of the workers compensation commissions’ oversight of claims
Changes in the cost of medical treatments (including prescription drugs) and underlying fee schedules
Change in average severity of accidents or proportion of severe accidents
The loss estimation process often begins with the identification of events with characteristics similar to the recent catastrophe (geographic location, wind speed, damageability, etc.), which then results in a list of the expected losses by contract from our proprietary risk management system. Third party modeling software is embedded in our proprietary risk management system.
Recorded gross reserves for general liability were $1,341.0 million, with approximately 4% of that amount related to run-off asbestos and environmental exposures as of December 31, 2013. For general liability losses relating to ongoing operations, reported loss development patterns are a key assumption for this line of business. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g., construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. We have reviewed the historical variation in reported loss development patterns for general liability losses deriving from continuing operations. If the reported loss development patterns change by 10%, a change that we have experienced in the past and that management considers possible, the estimated net reserve could change by $65.0 million, in either direction.
Recorded gross reserves for workers compensation were $541.3 million as of December 31, 2013. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately 60% of the workers compensation net reserves are related to future medical costs. A review of National Council on Compensation Insurance data suggests that the annual growth in industry medical claim costs has varied from -2% to +13% since 1991. Across the entire reserve base, a 1% change in calendar year medical inflation could change the estimated net reserve by $20.0 million, in either direction.
Deferred Tax Assets and Liabilities. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of Argo Group’s United States, Brazil, Ireland, Switzerland, Belgium, Malta and United Kingdom subsidiaries’ assets and liabilities. Deferred tax liabilities are recognized for temporary differences that will result in taxable amounts in future years. Deferred tax assets are recognized for deductible temporary differences and tax operating loss and tax credit carryforwards. The deferred tax assets and liabilities are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The components of our deferred tax asset are temporary differences primarily attributable to loss reserve discounting and unearned premium reserves. Our deferred tax liabilities resulted primarily from unrealized gains in the investment portfolio, deferred acquisition costs and from underwriting profits arising from business conducted at Lloyd’s which do not become subject to corporation tax in the United Kingdom until the year in which such profits are distributed.
For purposes of evaluating goodwill for impairment, management determined that our reporting units are the same as our business segments because all components of each segment are similar and none of the components were determined to be separate reporting units. Additionally, each business segment has discrete financial information available that is regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated and to assess performance. We allocated the assets, including goodwill, and liabilities of our reporting units consistent with our business segment reporting and prior periods. No material changes in the accounting methodology used to evaluate goodwill were made during 2013.
The fair value of reporting units was estimated using an average of three valuation methods: a comparable company analysis, precedent transaction analysis and discounted cash flow analysis. All three methods require management to make various judgments and assumptions including but not limited to: (i) market dynamics affecting each segment such as the competitive environment, pricing cycle and pricing outlook; the economy and interest rates, (ii) projections of earned premiums, losses, expenses and cash flows, and (iii) discount rates and valuation multiples. Assumptions about future cash flows are based on our budgets, business plans, economic projections, anticipated future cash flows and market data. Finally, the comparable company analysis and precedent transaction analysis required judgment in selecting comparable companies and comparable transactions for use in the calculations. These judgments and assumptions, and the outcomes in which they result, are potentially subject to material change based on factors, dynamics and influences outside of the control of management. In all instances, future changes in these judgments and assumptions could cause impairment of goodwill.
As noted above, we have elected to make the first day of the fourth quarter the annual impairment assessment date for goodwill and indefinite-lived intangible assets. An impairment analysis subsequent to this date has not been performed as management believes that no additional indicators of impairment have arisen, such as significant additional pricing competition, unexpected significant declines in operating results, divestiture of a significant component of the business or further significant decline in market capitalization.
Our market capitalization has increased in 2013; however, our stock has continued to trade below book value. Management considered the market capitalization below book value as a data point in performing its annual impairment test. Management considers the decline in our market capitalization to be primarily attributable to global financial market conditions, including the credit crisis, as well as current trends within the insurance industry. The valuation analysis discussed above supports management’s view that goodwill and indefinite-lived intangible assets are not impaired at October 1, 2013. Through December 31, 2013, there have been no indicators of impairment of goodwill and indefinite-lived intangible assets. During 2014, we will monitor relevant internal and external factors and their potential impact on the fair value of our reporting segments, and if required, we will update our impairment analysis.
We evaluated our definite lived intangibles for indicators of impairment. If indicators of impairment had been identified, we would have been required to test definite lived intangible assets for impairment. As of October 1, 2013, the testing date, no indicators of impairment were identified. Therefore, we were not required to test for impairment. As with the indefinite-lived intangible assets, we will continue to monitor for indicators of impairment and test as required.
The report of the independent auditors, consolidated financial statements of Argo Group International Holdings, Ltd. and supplementary financial statements called for by this Item 8 are included in this report beginning on page and are incorporated herein by reference.