The following is a discussion and analysis of our financial condition and results of operations for the twelve months ended December 31, 2017, 2016 and 2015. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties and that are not historical facts, including statements about our beliefs and expectations. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and particularly under the headings “Risk Factors,” “Business” and “Note on Forward-Looking Statements” contained in Item 1A, Item 1, and Part I of this Form 10-K, respectively.
Throughout this Form 10-K, our analysis of our financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with GAAP. Our results of operations have been presented in the way that we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use financial information in evaluating our performance. This presentation includes the use of underwriting profit and Adjusted EBITDA, which are “non-GAAP financial measures,” as such term is defined in Item 10(e) of Regulation S-K promulgated by the SEC. The presentation of these financial measures is not intended to be considered in isolation or as a substitute for, or superior to, financial information prepared and presented in accordance with GAAP. These measures may also be different from non-GAAP financial measures used by other companies, limiting their usefulness for comparison purposes. A discussion of our calculation and use of these financial measures is provided below.
Adjusted EBITDA is a non-GAAP financial measure for our non-insurance operating subsidiaries and investments held by Alleghany Capital. Adjusted EBITDA represents other revenue less certain other expenses and does not include: (i) depreciation expense (a component of other operating expenses); (ii) amortization of intangible assets; (iii) interest expense; (iv) net realized capital gains; (v) OTTI losses; and (vi) income taxes. Because Adjusted EBITDA excludes interest, income taxes, net realized capital gains, OTTI losses, depreciation and amortization, it provides an indication of economic performance that is not affected by levels of debt, interest rates, effective tax rates or levels of depreciation and amortization resulting from acquisition accounting. We use Adjusted EBITDA as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of certain of our non-insurance operating subsidiaries and investments. A reconciliation of Adjusted EBITDA to earnings before income taxes is presented within “Consolidated Results of Operations.”
Net earnings attributable to Alleghany stockholders were $90.1 million in 2017, compared with $456.9 million in 2016 and $560.3 million in 2015.
Earnings before income taxes were $36.7 million in 2017, compared with $647.8 million in 2016 and $757.4 million in 2015.
Net premiums written decreased by 2.5 percent in 2017 from 2016, and increased by 13.4 percent in 2016 from 2015.
Our underwriting loss was $316.4 million in 2017, compared with an underwriting profit of $401.3 million in 2016 and $466.6 million in 2015.
The combined ratio for our reinsurance and insurance segments was 106.4 percent in 2017, compared with 91.9 percent in 2016 and 89.0 percent in 2015.
Net favorable prior accident year loss reserve development was $298.6 million in 2017, compared with $368.0 million in 2016 and $215.5 million in 2015.
Earnings before income taxes for Alleghany Capital were $21.9 million in 2017, compared with losses before income taxes of $105.7 million in 2016 and $43.1 million in 2015. Adjusted EBITDA was $53.4 million in 2017, compared with $25.1 million in 2016 and $0.4 million in 2015.
As of December 31, 2017, we had total assets of $25.4 billion and total stockholders’ equity attributable to Alleghany stockholders of $8.5 billion. As of December 31, 2017, we had consolidated total investments of approximately $18.8 billion, consisting of $12.7 billion invested in debt securities, $4.1 billion invested in equity securities, $0.6 billion invested in short-term investments, $0.7 billion invested in commercial mortgage loans and $0.7 billion invested in other invested assets.
We incurred significant catastrophe losses in 2017, primarily arising from three major hurricanes. Hurricane Harvey caused widespread property damage and flooding in August 2017, primarily in the State of Texas. Hurricane Irma caused widespread property damage and flooding in September 2017, primarily in the State of Florida. Hurricane Maria caused widespread property damage and flooding in September 2017, primarily in the Commonwealth of Puerto Rico. Our loss estimates for these catastrophes are based on an analysis of reported claims, an underwriting review of in-force contracts, estimates of losses resulting from wind and other perils, including storm surge and flooding to the extent covered by applicable policies, and other factors requiring considerable judgment. The ultimate amount of our actual losses from these catastrophes may be materially different from these estimates due to the size and complexity of the events and the preliminary nature of the information available to prepare the estimates.
(2) Includes $97.6 million attributable to RSUI and $0.2 million attributable to CapSpecialty.
Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, we classify our businesses into two reportable segments - reinsurance and insurance. Other activities include Alleghany Capital and corporate activities. See Note 13 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on our segments and other activities. The tables below present the results for our segments and for other activities for the 2017, 2016 and 2015:
2017 vs 2016. The decrease in gross and net premiums written in 2017 from 2016 is primarily attributable to a decrease at our reinsurance segment, partially offset by an increase at our insurance segment, reflecting continued growth at CapSpecialty and PacificComp. The decrease at our reinsurance segment is primarily related to cancellations, non-renewals and reduced participations in certain treaties, the impact of rate pressures and increased retentions by cedants, partially offset by gross and net premiums written in 2017 related to reinstatement premiums written on treaties impacted by catastrophe losses. The decrease at our reinsurance segment in gross and net premiums written also reflects lower premiums related to a large whole account quota share treaty entered into in the fourth quarter of 2015, or the “Quota Share Treaty.” Premiums related to the Quota Share Treaty were $780.9 million and $854.3 million in 2017 and 2016, respectively. Premiums related to the Quota Share Treaty in 2016 reflect elevated premiums written in the first quarter of 2016 due to differences between initial premium estimates at contract inception, which were recorded in the fourth quarter of 2015, and actual data subsequently reported. As a consequence of this change in estimate, premiums written in the fourth quarter of 2015 were understated and premiums written in the first quarter of 2016 were correspondingly increased. In general, when actual data has not been reported by ceding companies, premiums written are estimated based on historical patterns and other relevant factors. Any differences between these estimates and actual data subsequently reported are recorded in the period when actual data becomes available.
The increase in net premiums earned in 2016 from 2015 primarily reflects an increase at our reinsurance segment for the reason discussed above.
A detailed comparison of premiums by segment for 2017, 2016 and 2015 is contained on pages 82, 83 and 90.
A detailed comparison of net loss and LAE by segment for 2017, 2016 and 2015 is contained on pages 84 through 86 and pages 91 through 93.
2017 vs 2016. The slight decrease in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflects a decrease at our reinsurance segment from the impact of lower net premiums earned and the impact of losses arising from Hurricanes Harvey, Irma and Maria on short-term incentive compensation expense accruals, largely offset by the impact of an increase at our insurance segment due to the impact of higher net premiums earned at CapSpecialty and PacificComp.
2016 vs 2015. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects an increase at our reinsurance segment due primarily to higher net premiums earned, as discussed above, partially offset by a slight decrease in employee-related overhead expenses.
A detailed comparison of commissions, brokerage and other underwriting expenses by segment for 2017, 2016 and 2015 is contained on pages 86, 87, 93 and 94.
2016 vs 2015. The decrease in underwriting profit in 2016 from 2015 reflects a decrease at our reinsurance segment due primarily to higher catastrophe and non-catastrophe losses in the 2016 accident year, partially offset by an increase in favorable prior accident year loss reserve development, all as discussed above.
A detailed comparison of underwriting profits by segment for 2017, 2016 and 2015 is contained on pages 87 and 94.
2017 vs 2016. The increase in net investment income in 2017 from 2016 primarily relates to higher interest income, partially offset by a decrease in income from other invested assets. The increase in interest income primarily reflects growth in funds withheld and commercial mortgage loan balances, higher yields on short term investments and floating-rate debt securities, as well as the fact that interest income in the fourth quarter of 2016 was reduced by approximately $7 million of adjustments made to more accurately reflect premium amortization associated with certain bonds. The decrease in income from other invested assets primarily reflects losses incurred on our equity interests in Pillar Capital Holdings Limited and related funds, or “Pillar Investments,” arising from catastrophe losses incurred in August and September 2017 and to a $12.6 million charge on our equity investment in Ares Management LLC, or “Ares” in early 2017. The charge on our equity investment in Ares reflects our share of a one-time payment recorded by Ares related to an acquisition by its affiliated entity. In connection with this acquisition, Ares agreed to make certain transaction support payments to the sellers of the acquired entity. Ares expects to receive future management fees derived from the assets under management of the acquired entity.
The decrease in net realized capital gains in 2016 from 2015 primarily reflects a $98.8 million capital loss due to an impairment charge from a write-down of certain SORC assets as of December 31, 2016 and lower gains from the sales of equity securities, partially offset by a $13.2 million realized gain recorded on April 15, 2016 by Alleghany Capital, as more fully described in the following pages, and a $25.8 million capital loss due to an impairment charge from a write-off of our
investment in ORX recorded on December 31, 2015. Realized capital gains from equity securities for 2015 includes the sales of certain equity securities resulting from a partial restructuring of the equity portfolio, as well as the sales of certain equity securities which had their cost basis reduced in earlier periods for the recognition of OTTI losses.
The decrease in OTTI losses in 2016 from 2015 primarily reflects the absence of losses on equity securities in the energy, pharmaceutical, gaming and airline sectors which were significant in 2015.
A detailed comparison of investment results for 2017, 2016 and 2015 is contained on pages 95 through 99.
Other revenue and Other operating expenses. Other revenue and other operating expenses primarily include sales revenues and expenses associated with Alleghany Capital. Other operating expenses also include the long-term incentive compensation of our reinsurance and insurance segments, which totaled $72.9 million, $76.1 million and $77.6 million in 2017, 2016 and 2015, respectively. The decrease in long-term incentive compensation at our reinsurance and insurance segments in 2017 from 2016 primarily reflects the impact of losses arising from Hurricanes Harvey, Irma and Maria, partially offset by the impact of an increase in unrealized appreciation on our equity and, to a lesser extent, bond portfolios, on long-term incentive compensation expense accruals at TransRe and RSUI. See Note 14 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information.
The increase in other revenue in 2017 from 2016 primarily reflects the acquisition of W&W|AFCO Steel. The increase in other operating expenses in 2017 from 2016 primarily reflects the acquisition of W&W|AFCO Steel and finder’s fees, legal and accounting costs and other transaction-related expenses at the Alleghany Capital level, partially offset by a decrease in the long-term incentive compensation of our reinsurance and insurance segments. On April 28, 2017, Alleghany Capital acquired approximately 80 percent of the equity in W&W|AFCO Steel for $164.5 million, including $163.9 million in cash paid on May 1, 2017 and $0.6 million of estimated purchase price adjustments.
The increase in other revenue and other operating expenses in 2016 from 2015 primarily reflects the acquisition of IPS on October 31, 2015, the inclusion of Jazwares in our consolidated results as of April 15, 2016 and, to a lesser extent, growth at Kentucky Trailer. On April 15, 2016, Alleghany Capital acquired an additional 50 percent of Jazwares’ outstanding equity, bringing its equity ownership interest to 80 percent and, as of that date, the results of Jazwares have been included in our consolidated results. Prior to April 15, 2016, Jazwares was accounted for under the equity method of accounting.
Corporate administration. The increase in corporate administration expense in 2017 from 2016 primarily reflects higher long-term incentive compensation expense accruals at Alleghany, driven by the impact of unrealized appreciation on our equity and, to a lesser extent, bond portfolios, partially offset by losses arising from Hurricanes Harvey, Irma and Maria. The decrease in corporate administration expense in 2016 from 2015 primarily reflects lower long-term incentive compensation expense accruals due mainly to the impact of less favorable financial results, partially offset by a rise in the price per share of our common stock during 2016.
Amortization of intangible assets. The increase in amortization expenses in 2017 from 2016 primarily reflects the amortization of net intangible assets related to the acquisition of W&W|AFCO Steel, partially offset by a decrease in amortization expense at IPS, as certain of IPS’s intangible assets were fully amortized as of December 31, 2016. Amortization expenses in 2016 reflect the amortization of net intangible assets, including intangible assets related to the acquisitions of IPS and Jazwares. Negative amortization expense in 2015 reflects the amortization of intangible liabilities acquired in our merger with TransRe in 2012, partially offset by the amortization of intangible assets. Amortization of intangible assets in 2015 also reflects the acquisition of IPS on October 31, 2015.
The Tax Cuts and Jobs Act of 2017, or the “Tax Act,” was signed into law on December 22, 2017. Among other provisions, the Tax Act reduced the corporate federal income tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018 for the 2018 tax year and, as a consequence, the value of our deferred tax assets and liabilities as of December 31, 2017 was reduced. The net impact of this reduction to our consolidated 2017 tax expense was not material. There currently exists a degree of uncertainty as to how certain provisions in the Tax Act will be interpreted and implemented in practice in the future.
2017 vs 2016. The decrease in earnings before income taxes and net earnings attributable to Alleghany stockholders in 2017 from 2016 primarily reflects significant catastrophe losses from Hurricanes Harvey, Irma and Maria at our reinsurance and insurance segments, as discussed above.
2016 vs 2015. The decrease in earnings before income taxes and net earnings attributable to Alleghany stockholders in 2016 from 2015 primarily reflects lower net realized capital gains and underwriting profits, partially offset by lower OTTI losses, all as discussed above.
Casualty & other. The decrease in gross premiums written in 2017 from 2016 primarily reflects cancellations, non-renewals and reduced participations in certain treaties, as well as the impact of rate pressures and increased retentions by cedants and a decrease in casualty-related premiums written related to the Quota Share Treaty, partially offset by reinstatement premiums written on treaties impacted by catastrophe losses. Gross premiums written related to the Quota Share Treaty were $416.6 million and $501.1 million in 2017 and 2016, respectively. Premiums related to the Quota Share Treaty in 2016 reflect elevated premiums written in the first quarter of 2016 due to differences between initial premium estimates at contract inception, which were recorded in the fourth quarter of 2015, and actual data subsequently reported. As a consequence of this change in estimate, premiums written in the fourth quarter of 2015 were understated and premiums written in the first quarter of 2016 were correspondingly increased. In general, when actual data has not been reported by ceding companies, premiums written are estimated based on historical patterns and other relevant factors. Any differences between these estimates and actual data subsequently reported are recorded in the period when actual data becomes available. Excluding the impact of changes in foreign currency exchange rates, gross premiums written decreased 5.6 percent in 2017 from 2016. The decrease in net premiums earned in 2017 from 2016 primarily reflects the decline in net premiums written in
recent quarters and the impact of changes in foreign currency exchange rates, partially offset by $4.3 million of net reinstatement premiums earned on treaties impacted by catastrophe losses. Excluding the impact of changes in foreign currency exchange rates, net premiums earned decreased 1.5 percent in 2017 from 2016.
Reinsurance Segment: Net loss and LAE. The following table presents net loss and LAE for the reinsurance segment.
Property. The increase in net loss and LAE in 2017 from 2016 primarily reflects higher catastrophe losses. Catastrophe losses in 2017 include $110.8 million related to Hurricane Harvey in August 2017, $128.1 million related to Hurricane Irma in September 2017, $181.3 million related to Hurricane Maria in September 2017, $69.2 million related to wildfires in the State of California in the fourth quarter of 2017, and $26.9 million related to earthquakes in Mexico in September 2017. The catastrophe losses in 2016 relate to wildfire losses in Alberta, Canada, earthquake losses in Japan,
earthquake losses in Ecuador, all of which occurred in the second quarter, typhoon and flood losses in China in the third quarter, earthquake losses from an earthquake in New Zealand in the fourth quarter and $21.8 million of losses from Hurricane Matthew, which caused property damage and flooding in the Southeast Coast of the U.S. in October.
(5) Reflects favorable prior accident year loss reserve development primarily related to the 2011 through 2015 accident years.
(6) Reflects favorable prior accident year loss reserve development primarily related to the 2013 and 2014 accident years.
(1) Represents certain medical malpractice treaties, or the “Malpractice Treaties,” pursuant to which the increased underwriting profits created by the favorable prior accident year loss reserve development are largely retained by the cedants. As a result, the favorable prior accident year loss reserve development is largely offset by an increase in profit commission expense incurred when such favorable prior accident year loss reserve development occurs.
(2) Represents unfavorable prior accident year loss reserve development arising from the U.K. Ministry of Justice’s decision to significantly reduce the discount rate, referred to as the Ogden rate, used to calculate lump-sum bodily injury payouts in personal injury insurance claims in the U.K. As of March 20, 2017, the Ogden rate changed from 2.50 percent to negative 0.75 percent.
(3) Represents unfavorable prior accident year development on Commuted A&E Liabilities related to the Commutation Agreement, as discussed above.
(4) Primarily reflects favorable prior accident year loss reserve development in: (i) longer-tailed professional liability and general liability lines of business related to the 2003 through 2012 accident years; and (ii) shorter-tailed casualty lines of business related to the 2010 through 2014 accident years; partially offset by unfavorable prior accident year loss reserve development in shorter-tailed casualty lines of business in the 2015 and 2016 accident years.
(6) Generally reflects favorable prior accident year loss reserve development in a variety of casualty & other lines of business primarily from the 2005 through 2014 accident years, including ($30.7) million of favorable prior accident year development related to French medical malpractice loss reserves commuted in the fourth quarter of 2015 with a European cedant, partially offset by unfavorable prior accident year development from the 2004 and prior accident years.
Reinsurance Segment: Commissions, brokerage and other underwriting expenses. The following table presents commissions, brokerage and other underwriting expenses for the reinsurance segment.
Property. The increase in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflects the impact of higher net premiums earned and an increase in commission rates, partially offset by lower short-term incentive compensation expense accruals arising from the significant catastrophe losses that occurred in 2017. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of higher net premiums earned, partially offset by a slight decrease in employee-related overhead expenses.
Reinsurance Segment: Underwriting profit. The following table presents our underwriting (loss) profit for the reinsurance segment.
Casualty & other. The decrease in underwriting profit in 2017 from 2016 primarily reflects significant catastrophe losses from Hurricanes Harvey, Irma and Maria, as well as less favorable prior accident year loss reserve development, as discussed above. The increase in underwriting profit in 2016 from 2015 primarily reflects an increase in favorable prior accident year loss reserve developments, as discussed above.
The insurance segment is comprised of AIHL’s RSUI, CapSpecialty and PacificComp (prior to its sale on December 31, 2017) operating subsidiaries. RSUI also writes a modest amount of assumed reinsurance business, which is included in the insurance segment. For a more detailed description of our insurance segment, see Part I, Item 1, “Business-Segment Information-Insurance Segment” of this Form 10-K.
RSUI. Gross premiums written in 2017 approximated those from 2016, primarily reflecting declines in the property and most casualty lines of business in the first nine months of 2017 arising from an increase in competition, offset by 2017 fourth quarter growth, due to an increase in business opportunities and improved general market conditions, particularly in the property lines of business. The decrease in gross premiums written in 2016 from 2015 primarily reflects declines in the property lines of business and, to a lesser extent, declines in RSUI’s other lines of business, all due to an increase in competition and a reduction in pricing.
The decreases in net premiums earned in 2017 from 2016 and in 2016 from 2015 primarily reflect a general trend of declining gross premiums written prior to the fourth quarter of 2017.
CapSpecialty. The increase in gross premiums written in 2017 from 2016 primarily reflects growth in the professional liability and miscellaneous medical lines of business due to CapSpecialty’s distribution initiatives and expanded product offerings. The increase in gross premiums written in 2016 from 2015 primarily reflects strong growth in the professional, environmental and construction lines of business due to CapSpecialty’s distribution initiatives and, to a lesser extent, an increase in the surety lines of business.
PacificComp. The increases in gross premiums written and net premiums earned in 2017 from 2016 and in 2016 from 2015 primarily reflect premium growth due to PacificComp’s distribution initiatives and growth in targeted segments of the workers’ compensation market in the State of California.
Insurance Segment: Net loss and LAE. The following table presents net loss and LAE for the insurance segment.
RSUI. The increase in net loss and LAE in 2017 from 2016 primarily reflects higher catastrophe losses. The decrease in net loss and LAE in 2016 from 2015 primarily reflects an increase in favorable prior accident year loss reserve development and the impact of lower net premiums earned, partially offset by higher catastrophe losses.
Net loss and LAE in 2017, 2016 and 2015 include (favorable) unfavorable prior accident year loss reserve development as presented in the table below:
(1) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess lines of business related to the 2005 through 2011 accident years.
(2) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business related to the 2006 through 2012 accident years.
CapSpecialty. The increase in net loss and LAE in 2017 from 2016 primarily reflects the impact of higher net premiums earned, higher 2017 accident year losses and less favorable prior accident year loss reserve development in 2017. Catastrophe losses in 2017 include $0.2 million related to Hurricane Harvey in August 2017 and $0.2 million related to Hurricane Irma in September 2017. The increase in net loss and LAE in 2016 from 2015 primarily reflects the impact of higher net premiums earned, partially offset by favorable prior accident year loss reserve development in 2016 compared with unfavorable prior accident year loss reserve development in 2015.
(3) Represents certain specialty lines of business written through a program administrator in connection with a terminated program related to the 2010 and 2009 accident years and reflects (favorable) loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
The favorable prior accident year loss reserve development in 2017 and 2016 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The unfavorable prior accident year loss reserve development in 2015 reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods. The favorable prior accident year loss reserve development in 2017 did not impact assumptions used in estimating CapSpecialty’s loss and LAE liabilities for business earned in 2017.
RSUI. The decrease in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflects the impact of lower net premiums earned and the impact of losses arising from Hurricanes Harvey, Irma and Maria on short-term incentive compensation expense accruals. The decrease in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of lower net premiums earned and relatively stable overhead expenses.
As decreases in net premiums earned exceeded the decreases in commissions, brokerage and other underwriting expenses, RSUI’s expense ratio increased in 2017 from 2016 and in 2016 from 2015.
PacificComp. The increase in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflects the impact of higher net premiums earned and relatively stable overhead expenses. The increase in commissions, brokerage and other underwriting expenses in 2016 from 2015 primarily reflects the impact of higher net premiums earned and relatively stable overhead expenses, partially offset by the deferral of certain acquisition costs for new business commencing in 2016.
Net Investment Income. The slight increase in net investment income in 2017 from 2016 primarily relates to higher interest income, partially offset by a decrease in income from other invested assets. The increase in interest income primarily reflects growth in funds withheld and commercial mortgage loan balances, higher yields on short term investments and floating-rate debt securities, as well as the fact that interest income in the fourth quarter of 2016 was reduced by approximately $7 million of adjustments made to more accurately reflect premium amortization associated with certain bonds. The decrease in income from other invested assets primarily reflects losses incurred on our equity interests in Pillar arising from catastrophe losses incurred in August and September 2017 and a $12.6 million charge on our equity investment in Ares. The charge on our equity investment in Ares reflects our share of a one-time payment recorded by Ares in early 2017 related to an acquisition by its affiliated entity. In connection with this acquisition, Ares agreed to make certain transaction support payments to the sellers of the acquired entity. Ares expects to receive future management fees derived from the assets under management of the acquired entity.
The decrease in net realized capital gains in 2016 from 2015 primarily reflects lower gains from the sales of equity securities. Realized capital gains in 2015 include the sales of certain equity securities resulting from a partial restructuring of the equity securities portfolio, as well as the sales of certain equity securities which had their cost basis reduced in earlier periods for the recognition of OTTI losses.
On April 28, 2017, Alleghany Capital acquired approximately 80 percent of the equity in W&W|AFCO Steel.
In October 2015, Alleghany Capital acquired a majority interest in IPS.
The changes in Alleghany Capital’s equity for 2017, 2016 and 2015 are presented below:
(1) Income taxes for certain Alleghany Capital subsidiaries are incurred at the Alleghany Capital level.
(2) For 2016, includes the purchase of an additional 50 percent of Jazwares’ outstanding equity on April 15, 2016.
(3) For 2017, primarily reflects the acquisition of W&W|AFCO Steel and the investment in Wilbert.
Net investment income. The increase in net investment income in 2017 from 2016 primarily reflects Alleghany Capital’s earnings from its Wilbert investment. The decrease in net investment income in 2016 from 2015 primarily reflects a cessation of equity method income from Jazwares upon our acquisition of a majority interest on April 15, 2016 and losses on other invested assets in 2016, partially offset by the absence of losses from ORX in 2016.
Other revenue and Other operating expenses. The increase in other revenue and other operating expenses in 2017 from 2016 primarily reflects the acquisition of W&W|AFCO Steel. The increase in other operating expenses in 2017 from
2016 also reflects finder’s fees, legal and accounting costs and other transaction-related expenses at the Alleghany Capital level. The increase in other revenue and other operating expenses in 2016 from 2015 primarily reflects the acquisition of IPS on October 31, 2015, the inclusion of Jazwares in our consolidated results as of April 15, 2016 and, to a lesser extent, growth at Kentucky Trailer.
Amortization of intangible assets. The decrease in amortization expenses in 2017 from 2016 primarily reflects a decrease in amortization expense at IPS, as certain of IPS’s intangible assets were fully amortized as of December 31, 2016, partially offset by amortization of net intangible assets related to the acquisition of W&W|AFCO Steel. The increase in amortization of intangible assets in 2016 from 2015 primarily reflects the amortization of intangible assets from the acquisitions of IPS and Jazwares.
Earnings (losses) before income taxes. The earnings before income taxes in 2017 compared with the loss before income taxes in 2016 primarily reflects the Jazwares Settlement Gain, and the impairment charge from the write-down of certain SORC assets in 2016, partially offset by the Jazwares Remeasurement Gain, all as discussed above. Earnings before income taxes in 2017 also reflect higher margins of the manufacturing and service operations, the inclusion of W&W|AFCO Steel and our investment in Wilbert. The increase in losses before income taxes in 2016 from 2015 primarily reflects the large impairment charge from a write-down of certain SORC assets, partially offset by the acquisitions of IPS and Jazwares, growth at Kentucky Trailer, the Jazwares Remeasurement Gain in 2016 and the impairment charge related to a write-off of our investment in ORX in 2015, all as discussed above.
Net investment income. The increase in net investment income in 2017 from 2016 primarily reflects higher income from new investments in other invested assets resulting from the purchase of certain non-marketable equity investments at the Alleghany parent company. The increase in net investment income in 2016 from 2015 primarily reflects higher income from other invested assets.
Net realized capital gains. The net realized capital gains in 2017 primarily reflect gains on the sale of certain exchange-traded funds. Net realized capital losses in 2016 primarily reflect the sale at a loss of equity securities in the mining and health care sectors. Net realized capital losses in 2015 primarily reflect the sale at a loss of equity securities in the energy sector.
Interest expense. Interest expense in 2017, 2016 and 2015 was approximately the same.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2017 and December 31, 2016. Gross and net loss and LAE reserves, and reinsurance recoverables as of December 31, 2017 increased from December 31, 2016, primarily reflecting significant catastrophe losses, partially offset by the sale of PacificComp, which closed on December 31, 2017. Catastrophe losses, net of reinsurance, in 2017 included $217.7 million related to Hurricane Harvey in August 2017, $252.1 million related to Hurricane Irma in September 2017, and $216.8 million related to Hurricane Maria in September 2017, all as discussed above.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2016 and December 31, 2015. Gross and net loss and LAE reserves as of December 31, 2016 increased from December 31, 2015, reflecting increases in our reinsurance and insurance segments. The increase in gross and net loss and LAE reserves at our reinsurance segment primarily reflects the impact of higher net premiums earned and higher catastrophe losses, partially offset by favorable prior accident year loss reserve development, all as discussed above. The increase in gross and net loss and LAE reserves at our insurance segment primarily reflects higher 2016 accident year losses and higher catastrophe losses, partially offset by favorable prior accident year loss reserve development, all as discussed above.
Our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines of business, improve risk-adjusted portfolio returns and enable them to increase gross premium writings and risk capacity without requiring additional capital. Our reinsurance and insurance subsidiaries purchase reinsurance and retrocessional coverages from highly-rated third-party reinsurers. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such reinsurance portion not paid by these reinsurers. As such, funds, trust agreements and letters of credit are held to collateralize a portion of our reinsurance and insurance subsidiaries’ reinsurance recoverables, and our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite or assume with multiple reinsurance programs.
As of December 31, 2017, our reinsurance and insurance subsidiaries had total reinsurance recoverables of $1,746.5 million, consisting of $1,650.1 million of ceded outstanding loss and LAE and $96.4 million of recoverables on paid losses. See Part I, Item 1, “Business - Reinsurance Protection” of this Form 10-K for additional information on the reinsurance purchased by our reinsurance and insurance subsidiaries.
The following table presents information regarding concentration of our reinsurance recoverables and the ratings profile of our reinsurers as of December 31, 2017:
In addition, the estimation of unpaid loss and LAE, including IBNR, for our reinsurance operations also takes into account assumptions with respect to many factors that will affect ultimate loss costs but are not yet known. The process by which actual carried reserves are determined considers not only actuarial estimates but a myriad of other factors. Such factors, both internal and external, which contribute to the variability and unpredictability of loss costs, include trends relating to jury awards, social trends, medical inflation, worldwide economic conditions, tort reforms, judicial interpretations of coverages, the regulatory environment, underlying policy pricing, terms and conditions and claims handling, among others. In addition, information gathered through underwriting and claims audits is also considered. We assess the reasonableness of our unpaid loss and LAE for our reinsurance operations using various actuarial methodologies, principally the paid development method, the reported loss development method and the Bornhuetter-Ferguson method as described below.
Methodologies and Assumptions. Our reinsurance and insurance subsidiaries use a variety of techniques that employ significant judgments and assumptions to establish the liabilities for unpaid loss and LAE recorded at the balance sheet date. These techniques include detailed statistical analyses of past claims reporting, settlement activity, claims frequency, internal loss experience, changes in pricing or coverages and severity data when sufficient information exists to lend statistical credibility to the analyses. More subjective techniques are used when statistical data is insufficient or unavailable. These liabilities also reflect implicit or explicit assumptions regarding the potential effects of future inflation, court resolutions and judicial interpretations, reinsurance coverage, legislative changes and recent trends in such factors, as well as a number of actuarial assumptions that vary across our reinsurance and insurance subsidiaries and across lines of business. This data is analyzed by line of business, coverage, accident year or underwriting year and reinsurance contract type, as appropriate.
The primary actuarial assumptions used by our reinsurance and insurance subsidiaries include the following:
Our net reserves for loss and LAE of $10.2 billion as of December 31, 2017 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(k) and Note 6 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our loss and LAE.
(15) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business related to the 2006 through 2011 accident years, partially offset by unfavorable prior accident year loss reserve development in the directors’ and officers’ liability lines of business related to the 2011 through 2014 accident years.
(20) Primarily reflects unfavorable prior accident year loss reserve development related to the casualty lines of business from the 2011 through 2013 accident years.
(23) Primarily reflects favorable prior accident year loss reserve development related to the 2012 and prior accident years.
Asbestos-Related Illness and Environmental Impairment Reserves. Loss and LAE include amounts for risks relating to asbestos-related illness and environmental impairment. The reserves carried for such claims, including the IBNR portion, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illness and environmental impairment losses. This uncertainty is due to, among other reasons, inconsistent and changing court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible future changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings. Although we are unable at this time to determine whether additional reserves, which could have a material adverse effect upon our results of operations, may be necessary in the future, we believe that our asbestos-related illness and environmental impairment reserves are adequate as of December 31, 2017. See Note 12(c) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” and pages 42 and 43 of this Form 10-K for additional information on loss and LAE for risks relating to asbestos-related illness and environmental impairment.
A three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Assets classified as Level 3 principally include certain residential mortgage-backed securities, or “RMBS,” commercial mortgage-backed securities, or “CMBS,” other asset-backed securities (primarily, collateralized loan obligations), U.S. and foreign corporate bonds (including privately issued securities), partnership investments and non-marketable equity investments. The valuation of Level 3 assets requires the greatest degree of judgment, as these valuations are based on techniques that use significant inputs that are unobservable. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, we consider factors specific to the asset.
market. Also, any changes made by the investee to the investment strategy of the non-marketable equity investments could result in significant changes to fair value that have a positive or negative correlation to the performance observed in the equity markets. For those investments whose performance is based on the results of operations within a specific industry, significant events impacting that industry could materially impact fair value. Also, decisions and changes to strategy made by management of the investee could result in positive or negative outcomes, which could significantly impact the results of operations of the investee and subsequently fair value.
In developing the cash flow analyses for debt securities, we consider various factors for the different categories of debt securities. For municipal bonds, we take into account the taxing power of the issuer, source of revenue, credit risk and
See Note 1(b) and Note 4(e) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our investments and investment impairments.
Goodwill and other intangible assets deemed to have an indefinite useful life are tested annually in the fourth quarter of every year for impairment. Goodwill and other intangible assets are also tested whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. A significant amount of judgment is required in performing goodwill and other intangible asset impairment tests. These tests may include estimating the fair value of our subsidiaries, which include Alleghany Capital’s operating subsidiaries, and other intangible assets. If it is determined that an asset has been impaired, the asset is written down by the amount of the impairment, with a corresponding charge to net earnings. Subsequent reversal of any impairment charge is not permitted.
Our consolidated balance sheet as of December 31, 2017 includes goodwill of $334.9 million related primarily to W&W|AFCO Steel, Jazwares, IPS, RSUI, CapSpecialty, Bourn & Koch and Kentucky Trailer, and intangible assets, net of amortization, of $459.0 million related primarily to TransRe, W&W|AFCO Steel, Jazwares, IPS, RSUI, CapSpecialty, Bourn & Koch and Kentucky Trailer. See Note 1(i) and Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our goodwill and other intangible assets.
General. In general, we follow a policy of maintaining a relatively liquid financial condition at our unrestricted holding companies. This policy has permitted us to expand our operations through internal growth at our subsidiaries and through acquisitions of, or substantial investments in, operating companies. As of December 31, 2017, we held total marketable securities and cash of $1,383.4 million, compared with $1,047.4 million as of December 31, 2016. The increase in 2017 primarily reflects cash consideration received in connection with the sale of PacificComp, as further described below, and the receipt of dividends from TransRe and RSUI, partially offset by contributions to Alleghany Capital to fund the acquisition of approximately 80 percent of the equity in W&W|AFCO Steel and the 45 percent equity interest in Wilbert, as well as the purchase of certain non-marketable equity investments at the Alleghany parent company. The $1,383.4 million is comprised of $577.8 million at the Alleghany parent company, $721.6 million at AIHL and $84.0 million at the TransRe holding company. We also hold certain non-marketable investments at our unrestricted holding companies. We believe that we have and will have adequate internally generated funds, cash resources and unused credit facilities to provide for the currently foreseeable needs of our business, and we had no material commitments for capital expenditures as of December 31, 2017.
Stockholders’ equity attributable to Alleghany stockholders was approximately $8.5 billion as of December 31, 2017, compared with approximately $7.9 billion as of December 31, 2016. The increase in stockholders’ equity in 2017 primarily reflects an increase in unrealized appreciation on our equity and, to a lesser extent, bond portfolios, as well as net earnings attributable to Alleghany stockholders in 2017. Net earnings attributable to Alleghany stockholders in 2017 were reduced by significant catastrophe losses from Hurricanes Harvey, Irma and Maria at our reinsurance and insurance segments, as discussed above. As of December 31, 2017, we had 15,390,500 shares of our common stock outstanding, compared with 15,410,164 shares of our common stock outstanding as of December 31, 2016.
Sale of Subsidiary. On September 12, 2017, AIHL signed a definitive agreement to sell PacificComp to CopperPoint for total cash consideration of approximately $158 million. The transaction closed on December 31, 2017, at which time: (i) approximately $442 million of PacificComp assets, consisting primarily of debt securities, and approximately $316 million of PacificComp liabilities, consisting primarily of loss and LAE reserves, were transferred; and (ii) AIHL recorded an after-tax gain of approximately $16 million, which included a tax benefit. In connection with the transaction, AIHL Re will continue to provide adverse development reinsurance coverage on PacificComp’s pre-acquisition claims, subject to certain terms and conditions. AIHL Re’s obligations, which are guaranteed by Alleghany, are subject to: (i) an aggregate limit of $150.0 million; and (ii) a final commutation and settlement as of December 31, 2024.
On June 26, 2012, we completed a public offering of $400.0 million aggregate principal amount of our 4.95% senior notes due on June 27, 2022, or the “2022 Senior Notes.” The 2022 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest on the 2022 Senior Notes is payable semi-annually on June 27 and December 27 of each year. The terms of the 2022 Senior Notes permit redemption prior to their maturity. The indenture under which the 2022 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2022 Senior Notes were issued at approximately 99.9 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $396.0 million and an effective yield of approximately 5.05 percent.
On September 20, 2010, we completed a public offering of $300.0 million aggregate principal amount of our 5.625% senior notes due on September 15, 2020, or the “2020 Senior Notes.” The 2020 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest on the 2020 Senior Notes is payable semi-annually on March 15 and September 15 of each year. The terms of the 2020 Senior Notes permit redemption prior to their maturity. The indenture under which the 2020 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2020 Senior Notes were issued at approximately 99.6 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $298.9 million and an effective yield of approximately 5.67 percent.
On April 13, 2015, S&P upgraded Alleghany’s issuer credit rating to “BBB+” from “BBB,” on January 27, 2016, Moody’s upgraded Alleghany’s issuer credit ratings to Baa1 from Baa2 and on August 19, 2016, A.M. Best upgraded Alleghany’s issuer credit rating to “a-” from “bbb+.”
Credit Agreement. On July 31, 2017, we entered into a five-year credit agreement, or the “Credit Agreement,” with certain lenders party thereto, which provides for an unsecured revolving credit facility in an aggregate principal amount of up to $300.0 million. The credit facility is scheduled to expire on July 31, 2022, unless earlier terminated. Borrowings under the Credit Agreement will be available for working capital and general corporate purposes, including permitted acquisitions and repurchases of Common Stock. Borrowings under the Credit Agreement bear a floating rate of interest based in part on our credit rating, among other factors. The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. There were no borrowings under the Credit Agreement from July 31, 2017 through December 31, 2017.
outstanding principal amount of the loans, as applicable, terminate the commitments, accelerate the repayment of any outstanding loans and exercise all rights and remedies available to such lenders under the Credit Agreement and applicable law. In the case of an event of default that exists due to the occurrence of certain involuntary or voluntary bankruptcy, insolvency or reorganization events of Alleghany, the commitments will automatically terminate and the repayment of any outstanding loans shall be automatically accelerated.
Dividends from Subsidiaries. As of December 31, 2017, approximately $6.6 billion of our total equity of $8.5 billion was unavailable for dividends or advances to us from our subsidiaries. The remaining $1.9 billion was available for dividends or advances to us from our subsidiaries, or was retained at the Alleghany parent level and, as such, was available to pay dividends to Alleghany’s stockholders as of December 31, 2017.
The following table presents the shares of our common stock that we repurchased in 2017, 2016 and 2015 pursuant to the 2014 Repurchase Program and the 2015 Repurchase Program, as applicable:
(3) Primarily reflect employee pension obligations, certain retired executive pension obligations and obligations under certain incentive compensation plans.
Investments in Certain Other Invested Assets. In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited, or “Pillar Holdings,” a Bermuda-based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities. Additionally, TransRe invested $175.0 million and AIHL invested $25.0 million in limited partnership funds managed by Pillar Holdings, or the “Funds.” The objective of the Funds is to create portfolios with attractive risk-reward characteristics and low correlation with other asset classes, using the extensive reinsurance and capital market experience of the principals of Pillar Holdings. We have concluded that the Pillar Investments represent variable interest entities and that we are not the primary beneficiary, as we do not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, the Pillar Investments are not consolidated and are accounted for under the equity method of accounting. Our potential maximum loss in the Pillar Investments is limited to our cumulative net investment. As of December 31, 2017, our carrying value in the Pillar Investments, as determined under the equity method of accounting, was $217.9 million, which is net of returns of capital received from the Pillar Investments.
In July 2013, AIHL invested $250.0 million in Ares in exchange for a 6.25 percent equity stake in Ares, with an agreement to engage Ares to manage up to $1.0 billion in certain investment strategies. In May 2014, Ares completed an initial public offering of its common units. Upon completion of the initial public offering, Alleghany’s equity investment in Ares converted to limited partner interests in certain Ares subsidiaries that are convertible into an aggregate 5.9 percent interest in Ares common units. These interests may be converted at any time at our discretion. Until we determine to convert our limited partner interests into Ares common units, we classify our investment in Ares as a component of other invested assets and we account for our investment using the equity method of accounting. As of December 31, 2017, AIHL’s carrying value in Ares was $212.4 million, which is net of returns of capital received from Ares.
Investments in Commercial Mortgage Loans. As of December 31, 2017, the carrying value of our commercial mortgage loan portfolio was $658.4 million, representing the unpaid principal balance on the loans. As of December 31, 2017, there was no allowance for loan losses. The commercial mortgage loan portfolio consists primarily of first mortgages on commercial properties in major metropolitan areas in the U.S. The loans earn interest at fixed- and floating-rates, mature in two to ten years from loan origination and the principal amounts of the loans were no more than approximately two-thirds of the property’s appraised value at the time the loans were made.
Financial strength is also a high priority of our subsidiaries, whose assets stand behind their financial commitments to their customers and vendors. We believe that our subsidiaries have and will have adequate internally generated funds, cash resources and unused credit facilities to provide for the currently foreseeable needs of their businesses. Our subsidiaries had no material commitments for capital expenditures as of December 31, 2017.
On December 14, 2015, the remaining $367.0 million outstanding aggregate principal amount of TransRe’s 2015 Senior Notes matured and was repaid.
With respect to our non-insurance operating subsidiaries, SORC has relied on Alleghany almost entirely to support its operations. From its formation in 2011 through December 31, 2017, we have invested $281.8 million in SORC.
Kentucky Trailer related primarily to a mortgage loan, borrowings to finance small acquisitions and borrowings under its available credit facility, and $4.3 million of borrowings by IPS under its available credit facility. None of these liabilities are guaranteed by Alleghany or Alleghany Capital.
(1) Consists of $210.1 million of securities rated BB / Ba, $304.0 million of securities rated B, $56.5 million of securities rated CCC, $5.8 million of securities rated CC, $4.7 million of securities rated below CC and $92.0 million of not-rated securities.
In the event paid losses accelerate beyond the ability of our reinsurance and insurance subsidiaries to fund these paid losses from current cash balances, current operating cash flow, dividend and interest receipts and security maturities, we would need to liquidate a portion of our investment portfolio, make capital contributions to our reinsurance and insurance subsidiaries, and/or arrange for financing. Strains on liquidity could result from: (i) the occurrence of several significant
Fair Value. The following table presents the carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2017 and 2016:
information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.
We employ specific control processes to determine the reasonableness of the fair values of our financial assets and liabilities. Our processes are designed to ensure that the values received or internally estimated are accurately recorded and that the data inputs and the valuation techniques used are appropriate, consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. We assess the reasonableness of individual security values received from valuation service providers through various analytical techniques. In addition, we validate the reasonableness of fair values by comparing information obtained from our valuation service providers to other third-party valuation sources for selected securities. We also validate prices obtained from brokers for selected securities through reviews by those who have relevant expertise and who are independent of those charged with executing investing transactions.
The following tables present the estimated fair values of our financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2017 and 2016:
Projections of potential catastrophe losses are typically expressed in terms of the probable maximum loss, or “PML.” We define PML as our anticipated maximum loss (taking into account contract limits) caused by a single catastrophe event at a specified estimated return period affecting a broad contiguous area. These modeled losses are estimated based upon contracts in force at January 1, 2018 for TransRe and December 1, 2017 for RSUI. Modeled results also reflect losses arising from certain of our invested assets that have specific catastrophe exposures.
“Florida, Wind” has the highest modeled after-tax net catastrophe costs for both a 100 and 250 year return period. These costs would represent approximately 6 percent and 8 percent, respectively, of stockholders’ equity attributable to Alleghany as of December 31, 2017, compared with approximately 5 percent and 7 percent, respectively, of stockholders’ equity attributable to Alleghany as of December 31, 2016. If multiple severe catastrophe events occur in any one year, or a
of the change in a liability’s fair value resulting from instrument-specific credit risk when an election has been made to measure the liability at fair value; and (iv) eliminating the requirement to disclose the methods and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet. This guidance is effective for fiscal years beginning after December 15, 2017 for public entities, including interim periods within those fiscal years. Except for the change in presentation for instrument-specific credit risk, this guidance does not permit early adoption. We will adopt this guidance in the first quarter of 2018. As of January 1, 2018, approximately $734 million of net unrealized gains of equity securities, net of deferred taxes, were reclassified from accumulated other comprehensive income to retained earnings. Subsequently, all changes in unrealized gains or losses of equity securities, net of deferred taxes, will be presented in the Consolidated Statements of Earnings rather than the Consolidated Statements of Comprehensive Income. The implementation did not have a material impact on our financial condition. See Note 4(a) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our unrealized gains and losses of equity securities.
In February 2016, the FASB issued guidance on leases. Under this guidance, a lessee is required to recognize lease liabilities and corresponding right-of-use assets for leases with terms of more than one year, whereas under current guidance, a lessee is only required to recognize assets and liabilities for those leases qualifying as capital leases. This guidance also requires new disclosures about the amount, timing and uncertainty of cash flows arising from leases. The accounting by lessors is to remain largely unchanged. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. A modified retrospective transition approach is required for all leases in existence as of, or entered into after, the beginning of the earliest comparative period presented in the financial statements. We will adopt this guidance in the first quarter of 2019 and do not currently believe that the implementation will have a material impact on our results of operations and financial condition. See Note 12(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our leases.
In August 2017, the FASB issued guidance that simplifies the requirements to achieve hedge accounting, better reflects the economic results of hedging in the financial statements and better aligns hedge accounting with a company’s risk management activities. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. We will adopt this guidance in the first quarter of 2019 and do not currently believe that the implementation will have a material impact on our results of operations and financial condition.
We have audited the accompanying consolidated balance sheets of Alleghany Corporation and subsidiaries (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and the financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the consolidated financial position of Alleghany Corporation and subsidiaries at December 31, 2017 and 2016, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Alleghany Corporation (“Alleghany”), a Delaware corporation owns and manages certain operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance. Through its wholly-owned subsidiary TransRe, Alleghany is engaged in the property and casualty reinsurance business. TransRe has been Alleghany’s wholly-owned subsidiary since March 2012. Through its wholly-owned subsidiary Alleghany Insurance Holdings LLC (“AIHL”) and its subsidiaries, Alleghany is engaged in the property and casualty insurance business. AIHL’s insurance operations are principally conducted by its subsidiaries RSUI Group, Inc. (“RSUI”), CapSpecialty, Inc. (“CapSpecialty”) and, prior to December 31, 2017, Pacific Compensation Corporation (“PacificComp”). CapSpecialty has been a subsidiary of AIHL since January 2002, RSUI has been a subsidiary of AIHL since July 2003 and PacificComp had been a subsidiary of AIHL since July 2007. AIHL Re LLC (“AIHL Re”), a captive reinsurance company which provides reinsurance to Alleghany’s current and former insurance operating subsidiaries and affiliates, has been a wholly-owned subsidiary of Alleghany since its formation in May 2006.
Although Alleghany’s primary sources of revenues and earnings are its reinsurance and insurance operations and investments, Alleghany also sources, executes, manages and monitors certain private investments primarily through its wholly-owned subsidiary Alleghany Capital Corporation (“Alleghany Capital”). Alleghany Capital’s investments are included in other activities for segment reporting purposes and include:
WWSC Holdings, LLC (“W&W|AFCO Steel”), a structural steel fabricator and erector, headquartered in Oklahoma City, Oklahoma; and
The results of IPS have been included in Alleghany’s consolidated results beginning with its acquisition by Alleghany Capital on October 31, 2015. On April 15, 2016, Alleghany Capital acquired an additional 50 percent of Jazwares’
Wilbert is accounted for under the equity method of accounting and is included in other invested assets. The results of Wilbert have been included in Alleghany’s consolidated results beginning with its acquisition for $72.3 million by Alleghany Capital on August 1, 2017.
In addition, Alleghany owns and manages properties in the Sacramento, California region through its wholly-owned subsidiary Alleghany Properties Holdings LLC (“Alleghany Properties”). Alleghany owned an approximately 15 percent equity interest in ORX Exploration, Inc. (“ORX”), a regional oil and gas exploration and production company, until it was sold on December 23, 2016. Alleghany’s public equity investments are managed primarily through Alleghany’s wholly-owned subsidiary Roundwood Asset Management LLC.
Unless the context otherwise requires, references to “Alleghany” include Alleghany together with its subsidiaries.
The portion of stockholders’ equity, net earnings and accumulated other comprehensive income that is not attributable to Alleghany stockholders is presented on the Consolidated Balance Sheets, the Consolidated Statements of Earnings and Comprehensive Income and the Consolidated Statements of Changes in Stockholders’ Equity as noncontrolling interests. Because all noncontrolling interests have the option to sell their ownership interests to Alleghany in the future (generally through 2024), the portion of stockholders’ equity that is not attributable to Alleghany stockholders is presented on the Consolidated Balance Sheets and the Consolidated Statements of Changes in Stockholders’ Equity as redeemable noncontrolling interests for all periods presented. During 2017, Bourn & Koch had approximately 11 percent noncontrolling interests outstanding, Kentucky Trailer had approximately 21 percent noncontrolling interests outstanding, IPS had approximately 16 percent noncontrolling interests outstanding and Jazwares had approximately 20 percent noncontrolling interests outstanding. W&W|AFCO Steel had approximately 20 percent noncontrolling interests outstanding from its April 28, 2017 acquisition date through December 31, 2017.
AFS securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect, applicable to AFS securities, as well as partnership investments that Alleghany accounts for as AFS, are excluded from earnings and reflected in comprehensive income, and the cumulative effect is reported as a separate component of
Unobservable inputs, significant to the measurement and valuation of mortgage-backed and asset-backed securities, are generally used in the income approach, and include assumptions about prepayment speed and collateral performance, including default, delinquency and loss severity rates. Significant changes to any one of these inputs, or combination of inputs, could significantly change the fair value measurement for these securities.
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. Current tax liabilities or assets are recognized for the estimated taxes payable or refundable on tax returns for the current year.
As noted above, as of any balance sheet date, not all claims that have occurred have been reported to Alleghany, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled is referred to as the “claim tail.” Reported losses for the shorter-tailed classes, such as property, generally reach the ultimate level of incurred losses in a relatively short period of time and as such, are only relevant for the more recent accident years.
See Note 8 for additional information on the Senior Notes and other debt.
Noninsurance revenues and related operating expenses arising from the sale of manufactured goods and services is generally recognized as the transfer of goods and services to customers takes place. Noninsurance revenues reflect the
In March 2017, the Financial Accounting Standards Board (the “FASB”) issued guidance that reduces the amortization period for the premium on certain purchased callable debt securities to the earliest call date. The guidance applies specifically to noncontingent call features that are callable at a predetermined and fixed price and date. The accounting for purchased callable debt securities held at a discount is not affected. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. Alleghany has adopted this guidance in the fourth quarter of 2017, and recorded a cumulative effect reduction of approximately $13 million directly to opening 2017 retained earnings and an offsetting increase in opening 2017 accumulated other comprehensive income. The implementation did not have a material impact on Alleghany’s results of operations and financial condition.
In May 2014, the FASB, together with the International Accounting Standards Board, issued guidance on the recognition of revenue from contracts with customers. Under this guidance, revenue is recognized as the transfer of goods and services to customers takes place and in amounts that reflect the payment or payments that are expected to be received from the customers for those goods and services. This guidance also requires new disclosures about revenue. Revenues related to insurance and reinsurance contracts and revenues from investments are not impacted by this guidance, whereas noninsurance revenues arising from the sale of manufactured goods and services is generally included within the scope of this guidance. This guidance is effective in the first quarter of 2018 for public entities, with early adoption permitted in 2017. Alleghany will adopt this guidance in the first quarter of 2018 using the modified retrospective transition approach. Alleghany has completed an analysis of its noninsurance revenues and has concluded that the implementation did not have a material impact on its results of operations and financial condition.
In August 2017, the FASB issued guidance that simplifies the requirements to achieve hedge accounting, better reflects the economic results of hedging in the financial statements and better aligns hedge accounting with a company’s risk management activities. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. Alleghany will adopt this guidance in the first quarter of 2019 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
The following table presents the amount of goodwill and intangible assets, net of accumulated amortization expense, reported on Alleghany’s consolidated balance sheets as of December 31, 2017 and 2016:
brokerage and reinsurance relationships - 15 years; renewal rights - between 5 and 14 years; loss and LAE reserves - 15 years; and leases - 10 years. The economic useful life of license agreements is 8 years and of customer relationships is between 5 and 10 years.
The following tables present Alleghany’s financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2017 and 2016:
In 2017, Alleghany transferred $77.8 million of financial instruments out of Level 3 principally due to an increase in observable inputs related to the valuation of such assets and, specifically, an increase in broker quotes. Of the $77.8 million of transfers, $36.2 million related to other asset-backed securities, $21.3 million related to U.S. corporate bonds and $20.3 million related to several other types of securities.
Net unrealized losses related to Level 3 investments as of December 31, 2017 and 2016 were not material.
The following tables present the amortized cost or cost and the fair value of AFS securities as of December 31, 2017 and 2016:
(1) Includes $1,101.3 million and $903.8 million of collateralized loan obligations as of December 31, 2017 and 2016, respectively.
The following table presents net investment income for 2017, 2016 and 2015:
Capital’s acquisition of an additional 50 percent equity ownership in Jazwares, when its pre-existing 30 percent equity ownership was remeasured at estimated fair value (the “Jazwares Remeasurement Gain”), and a $98.8 million capital loss incurred by Alleghany Capital due to an impairment charge from a write-down of certain SORC assets. Realized capital gains and losses for 2015 generally reflect sales of equity securities.
The following table presents the amount of gross realized capital gains and gross realized capital losses in 2017, 2016 and 2015:
Management’s assessment of equity securities initially involves an evaluation of all securities that are in an unrealized loss position, regardless of the duration or severity of the loss, as of the applicable balance sheet date. Such initial review consists primarily of assessing whether: (i) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; and (ii) Alleghany has the ability and intent to hold an equity security for a period of time sufficient to allow for an anticipated recovery (generally considered to be 12 months from the balance sheet date).
As of December 31, 2017, the vast majority of Alleghany’s debt securities were rated investment grade, with 5.3 percent of debt securities having issuer credit ratings that were below investment grade or not rated, compared with 5.1 percent as of December 31, 2016.
The following table presents information regarding concentration of Alleghany’s reinsurance recoverables and the ratings profile of its reinsurers as of December 31, 2017:
(2) Represents the A.M. Best Company, Inc. financial strength rating for the applicable reinsurance subsidiary or subsidiaries from which the reinsurance recoverable is due.
(5) Approximately 78 percent of Alleghany’s reinsurance recoverables balance as of December 31, 2017 was due from reinsurers having an A.M. Best Company, Inc. financial strength rating of A (Excellent) or higher.
Reinsured loss and LAE ceded included in Alleghany’s consolidated statements of earnings were $777.4 million, $325.8 million and $309.6 million for 2017, 2016 and 2015, respectively.
TransRe enters into retrocession arrangements, including property catastrophe retrocession arrangements, in order to reduce the effect of individual or aggregate exposure to losses, reduce volatility in specific lines of business, improve risk-adjusted portfolio returns and increase gross premium writings and risk capacity without requiring additional capital.
(2) Primarily represents the impact on net reserves arising from the sale of PacificComp on December 31, 2017.
(7) Represents certain medical malpractice treaties pursuant to which the increased underwriting profits created by the favorable prior accident year loss reserve development are largely retained by the cedants. As a result, the favorable prior accident year loss reserve development is largely offset by an increase in profit commission expense incurred when such favorable prior accident year loss reserve development occurs.
(8) Represents unfavorable prior accident year loss reserve development arising from the U.K. Ministry of Justice’s decision to significantly reduce the discount rate, referred to as the Ogden rate, used to calculate lump-sum bodily injury payouts in personal injury insurance claims in the U.K. As of March 20, 2017, the Ogden rate changed from 2.50 percent to negative 0.75 percent.
(11) Generally reflects favorable prior accident year loss reserve development reserves in a variety of casualty & other lines of business primarily from the 2003 through 2015 accident years.
(18) Primarily reflects favorable prior accident year development of ($4.1) million from Super Storm Sandy in 2012, net of reinsurance, and favorable prior accident year loss reserve development related to unallocated LAE reserves.
The following is information about incurred and paid loss and LAE development, net of reinsurance. The information for accident years 2008 through 2015 is unaudited and is provided as supplementary information. Information is also included for the portion of unpaid loss and LAE, net of reinsurance recoverables, that relate to IBNR and, for the insurance segment, the cumulative number of reported insurance claims. For the reinsurance segment, reported insurance claim information is generally not received from the cedants, and such information is therefore impracticable to disclose.
Reinsurance Segment - Casualty & Other - Longer-Tailed Lines of Business(1)
(1) Represents the following reinsurance lines of business: directors’ and officers’ liability; errors and omissions liability; general liability; and medical malpractice.
(1) Primarily represents the following reinsurance lines of business: ocean marine and aviation; auto liability; accident and health; surety; and credit.
On June 26, 2012, Alleghany completed a public offering of $400.0 million aggregate principal amount of its 4.95% senior notes due on June 27, 2022 (the “2022 Senior Notes”). The 2022 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest on the 2022 Senior Notes is payable semi-annually on June 27 and December 27 of each year. The terms of the 2022 Senior Notes permit redemption prior to their maturity. The indenture under which the 2022 Senior Notes were issued contains covenants that impose conditions on Alleghany’s ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2022 Senior Notes were issued at approximately 99.9 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $396.0 million and an effective yield of approximately 5.05 percent.
On November 23, 2009, TransRe completed a public offering of $350.0 million aggregate principal amount of its 8.00% senior notes due on November 30, 2039 (the “2039 Senior Notes”). The 2039 Senior Notes are unsecured and unsubordinated general obligations of TransRe and are not guaranteed by Alleghany. Interest on the 2039 Senior Notes is payable semi-annually. The terms of the 2039 Senior Notes permit redemption prior to their maturity. The indentures under which the 2039 Senior Notes were issued contain covenants that impose conditions on TransRe’s ability to create liens on, or
The debt associated with Alleghany Capital’s operating subsidiaries totaled $101.0 million and $92.8 million as of December 31, 2017 and 2016, respectively. As of December 31, 2017, the $101.0 million includes $38.2 million of borrowings by W&W|AFCO Steel under its available credit facility and term loans, $33.3 million of borrowings by Jazwares under its available credit facility, $15.1 million of term loans at Bourn & Koch related to borrowings to finance an acquisition, $10.1 million of debt at Kentucky Trailer related primarily to a mortgage loan, borrowings to finance small acquisitions and borrowings under its available credit facility, and $4.3 million of borrowings by IPS under its available credit facility. None of these liabilities are guaranteed by Alleghany or Alleghany Capital.
The effective tax rate in 2017 compared with 2016 primarily reflects income tax benefits from taxable losses arising from Hurricanes Harvey, Irma and Maria in 2017 and, to a lesser extent, a tax benefit associated with the December 31, 2017 sale of PacificComp, as well as prior period income tax expense adjustments in 2016, which include $16.1 million of out-of-period reductions to current and deferred TransRe tax assets recorded in 2016 that related primarily to periods prior to Alleghany’s merger with TransRe in 2012.
The Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was signed into law on December 22, 2017. Among other provisions, the Tax Act reduced the corporate federal income tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018 for the 2018 tax year, and, as a consequence, the value of Alleghany’s deferred tax assets and liabilities as of December 31, 2017 was reduced. The net impact of this reduction to Alleghany’s consolidated 2017 tax expense was not material. There currently exists a degree of uncertainty as to how certain provisions in the Tax Act will be interpreted and implemented in practice in the future.
use its foreign tax credit carryforwards and its minimum tax credit carryforwards. The total amount of foreign tax credit carryforwards and minimum tax credit carryforwards that were available prior to the merger are not diminished by this provision. The limitation provides for an annual limit on the amount of the carryforwards that can be used each year. The unused carryovers are available to be used in subsequent years, subject to the annual limitation. The annual limitation is estimated at approximately $42.7 million.
Alleghany believes that, as of December 31, 2017, it had no material uncertain tax positions. Interest and penalties relating to unrecognized tax expenses (benefits) are recognized in income tax expense, when applicable. There were no material liabilities for interest or penalties accrued as of December 31, 2017.
The following table presents the shares of Common Stock that Alleghany repurchased pursuant to the 2014 Repurchase Program and the 2015 Repurchase Program, as applicable:
The following table presents dividends paid to Alleghany by its reinsurance and insurance subsidiaries in 2017, 2016 and 2015:
78,345, 68,429 and 77,441 contingently issuable shares were potentially available during 2017, 2016 and 2015, respectively, but were not included in the diluted earnings per share computations because the impact was anti-dilutive to the earnings per share calculation.
As of December 31, 2017, Alleghany had holdings in energy sector businesses of $977.6 million, comprised of $349.3 million of debt securities, $485.0 million of equity securities and $143.3 million of Alleghany’s equity attributable to SORC.
Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, Alleghany classifies its business into two reportable segments - reinsurance and insurance. Other activities include Alleghany Capital and corporate activities. In addition, reinsurance and insurance underwriting activities are evaluated separately from investment and other activities. Net realized capital gains and OTTI losses are not considered relevant in evaluating investment performance on an annual basis. Segment accounting policies are described in Note 1.
The insurance segment consists of property and casualty insurance operations conducted in the U.S. by AIHL through its insurance operating subsidiaries RSUI, CapSpecialty and, prior to its sale on December 31, 2017, PacificComp. RSUI also writes a modest amount of assumed reinsurance business, which is included in the insurance segment.
(1) Primarily consists of the following assumed reinsurance lines of business: directors’ and officers’ liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; surety; and credit.
(3) Includes amortization associated with deferred acquisition costs of $1,261.7 million, $1,253.2 million and $1,024.5 million for the years ended December 31, 2017, 2016 and 2015, respectively.
(4) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, OTTI losses, other revenue, other operating expenses, corporate administration, amortization of intangible assets or interest expense. Underwriting profit does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. Rather, Alleghany believes that underwriting profit enhances the understanding of its reinsurance and insurance segments’ operating results by highlighting net earnings attributable to their underwriting performance. Earnings before income taxes (a GAAP measure) may show a profit despite an underlying underwriting loss. Where underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. Therefore, Alleghany views underwriting profit as an important measure in the overall evaluation of performance.
Foreign net premiums earned in 2017, 2016 and 2015 were all approximately $1.4 billion. The foreign country in which Alleghany generates the largest amount of premium revenues is the U.K. Net premiums earned by operations in the U.K. in 2017, 2016 and 2015 were $612.1 million, $622.3 million and $640.4 million, respectively.
As of December 31, 2017, the identifiable assets of the reinsurance segment, insurance segment and other activities were $16.7 billion, $6.9 billion and $1.8 billion, respectively, of which cash and invested assets represented $13.6 billion, $5.3 billion and $0.6 billion, respectively. As of December 31, 2017, Alleghany’s equity attributable to the reinsurance segment, insurance segment and other activities was $5.2 billion, $3.0 billion and $0.3 billion, respectively.
Significant portions of the reinsurance segment’s gross premiums written are produced by a limited number of brokers. Gross premiums written produced by the reinsurance segment’s three largest brokers were approximately 24 percent, 19 percent, and 16 percent in 2017, 25 percent, 20 percent and 16 percent in 2016 and approximately 26 percent, 20 percent and 10 percent in 2015.
A large whole account quota share treaty entered into in the fourth quarter of 2015 accounted for approximately 19 percent in 2017, 20 percent in 2016 and 6 percent in 2015 of gross premiums written in the reinsurance segment.
As of December 31, 2017, Alleghany had long-term compensation plans for parent company-level employees and directors. Parent company-level, long-term compensation awards to current employees do not include stock options but consist only of restricted stock awards, including restricted stock units and performance share awards. Parent company-level, long-term compensation awards to non-employee directors consist of annual grants of restricted shares and restricted stock units of Common Stock.
The annual grant to each non-employee director consists of either restricted shares or restricted stock units, at the director’s election. Awards granted to non-employee directors were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2017.
BVUs outstanding. BVUs have vesting dates of up to approximately the fourth anniversary of the date of grant. The fair value of MTIP awards is calculated based on underwriting results compared to specified targets. MTIP awards have vesting dates of approximately the second or third anniversary of the date of grant. The BVUs and MTIP awards contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2017, 2016 and 2015, TransRe recorded $46.6 million, $50.7 million and $54.9 million, respectively, in compensation expense and a deferred tax benefit of $9.8 million, $17.7 million and $19.2 million, respectively, related to the TransRe Plans.
These employee retirement plans are not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2017.
(2) Earnings per share by quarter may not equal the amount for the full year due to the timing of repurchases of Common Stock, as well as rounding.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017 and the related notes and the financial statement schedules listed in the Index at Item 15(a)(2) of the Company and our report dated February 21, 2018 expressed an unqualified opinion thereon.