On April 2, 2019, a 3-for-2 common stock split was paid in the form of a stock dividend to holders of record as of March 14, 2019. Shares outstanding and per share amounts in this Form 10-K reflect this 3-for-2 common stock split effected on April 2, 2019.
The following presents a discussion of accounting policies and estimates relating to reserves for losses and loss expenses, assumed reinsurance premiums and other-than-temporary impairments of investments. Management believes these policies and estimates are the most critical to its operations and require the most difficult, subjective and complex judgments.
The key assumptions used to arrive at the best estimate of loss reserves are the expected loss ratios, rate of loss cost inflation, and reported and paid loss emergence patterns. Expected loss ratios represent management’s expectation of losses at the time the business is priced and written, before any actual claims experience has emerged. This expectation is a significant determinant of the estimate of loss reserves for recently written business where there is little paid or incurred loss data to consider. Expected loss ratios are generally derived from historical loss ratios adjusted for the impact of rate changes, loss cost trends and known changes in the type of risks underwritten. Expected loss ratios are estimated for each key line of business within each operating unit. Expected loss cost inflation is particularly important for the long-tail lines, such as excess casualty, and claims with a high medical component, such as workers’ compensation. Reported and paid loss emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value. Loss development factors are based on the historical emergence patterns of paid and incurred losses, and are derived from the Company’s own experience and industry data. The paid loss emergence pattern is also significant to excess and assumed workers’ compensation reserves because those reserves are discounted to their estimated present value based upon such estimated payout patterns. Management believes the estimates and assumptions it makes in the reserving process provide the best estimate of the ultimate cost of settling claims and
related expenses with respect to insured events which have occurred; however, different assumptions and variables could lead to significantly different reserve estimates.
Our net reserves for losses and loss expenses of approximately $10.7 billion as of December 31, 2019 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. The impact of such changes would likely be manifested gradually over the course of many years, as the magnitude of the changes became evident.
Reinsurance & Monoline Excess - Reserves for the Reinsurance & Monoline Excess segment developed favorably by $7 million in 2017. This favorable development was primarily due to excess workers’ compensation business, and was spread across many accident years, including years prior to 2008. The favorable excess workers’ compensation development resulted due to the same causes discussed above for workers’ compensation in the Insurance segment.
The favorable excess workers’ compensation development was largely offset by adverse development on U.K. assumed casualty reinsurance, as well as on U.S. facultative casualty excess of loss business. The adverse development on the U.K. casualty reinsurance was due to reserve strengthening associated with claims impacted by the change in the Ogden discount rate in the U.K. The Ogden rate is the discount rate used to calculate lump-sum bodily injury payouts in the U.K., and was reduced by the U.K. Ministry of Justice from +2.5% to -0.75%; the adverse development mostly related to U.K. motor bodily injury claims which we reinsured on an excess of loss basis in accident years 2012 through 2016. The adverse development on U.S. facultative casualty business was due to construction related risks in accident years 2008 and prior.
Reserve Discount. The Company discounts its liabilities for certain workers’ compensation reserves. The amount of workers’ compensation reserves that were discounted was $1,731 million and $1,793 million at December 31, 2019 and 2018, respectively. The aggregate net discount for those reserves, after reflecting the effects of ceded reinsurance, was $530 million and $563 million at December 31, 2019 and 2018, respectively. At December 31, 2019, discount rates by year ranged from 2.0% to 6.5%, with a weighted average discount rate of 3.7%.
Other-Than-Temporary Impairments (OTTI) of Investments. The cost of securities is adjusted where appropriate to include a provision for decline in value which is considered to be other-than-temporary. An other-than-temporary decline is considered to occur in investments where there has been a sustained reduction in fair value and where the Company does not expect the fair value to recover prior to the time of sale or maturity.
The portion of the decline in value considered to be a credit loss (i.e., the difference between the present value of cash flows expected to be collected and the amortized cost basis of the security) is recognized in earnings. The portion of the decline in value not considered to be a credit loss (i.e., the difference in the present value of cash flows expected to be collected and the fair value of the security) is recognized in other comprehensive income.
Independent pricing services - Substantially all of the Company’s fixed maturity securities available for sale were priced by independent pricing services (generally one U.S. pricing service plus additional pricing services with respect to a limited number of foreign securities held by the Company). The prices provided by the independent pricing services are generally based on observable market data in active markets (e.g., broker quotes and prices observed for comparable securities). The determination of whether markets are active or inactive is based upon the volume and level of activity for a particular asset class. The Company reviews the prices provided by pricing services for reasonableness based upon current trading levels for similar securities. If the prices appear unusual to the Company, they are re-examined and the value is either confirmed or revised. In addition, the Company periodically performs independent price tests of a sample of securities to ensure proper valuation and to verify our understanding of how securities are priced. As of December 31, 2019, the Company did not make any adjustments to the prices provided by the pricing services. Based upon the Company’s review of the methodologies used by the independent pricing services, these securities were classified as Level 2.
and subordination levels. Discount rates are adjusted to reflect illiquidity where appropriate. These securities were classified as Level 3.
Following is a summary of gross and net premiums written, net premiums earned, loss ratios (losses and loss expenses incurred expressed as a percentage of net premiums earned), expense ratios (underwriting expenses expressed as a percentage of net premiums earned) and GAAP combined ratios (sum of loss ratio and expense ratio) for each of our business segments for the years ended December 31, 2019 and 2018. The GAAP combined ratio represents a measure of underwriting profitability, excluding investment income. A GAAP combined ratio in excess of 100 indicates an underwriting loss; a number below 100 indicates an underwriting profit.
Net Income to Common Stockholders. The following table presents the Company’s net income to common stockholders and net income per diluted share for the years ended December 31, 2019 and 2018.
The Company reported net income of $682 million in 2019 compared to $641 million in 2018. The 6% increase in net income was primarily due to an after-tax increase in underwriting income of $91 million, an increase in income from minority interest of $6 million, an after-tax decrease in interest expense of $3 million, a $3 million increase in after-tax foreign currency gains, a $2 million decrease in tax expense, and an after-tax increase in other income of $2 million, partially offset by a decrease in after-tax net investment gains of $27 million, an after-tax decrease in net investment income of $23 million mainly driven by investment funds, an after-tax increase in corporate expenses of $6 million, an after-tax reduction in insurance service fee income of $6 million, and an after-tax decrease in income from non-insurance businesses of $4 million. The number of weighted average diluted shares slightly increased due to shares granted through an equity compensation based plan.
Average renewal premium rates for insurance and facultative reinsurance increased 4.8% in 2019 and 2.5% in 2018, when adjusted for changes in exposures. Average renewal premium rates for insurance and facultative reinsurance excluding workers' compensation increased 6.9% in 2019 and 4.0% in 2018, when adjusted for changes in exposures.
Insurance gross premiums increased 6% to $7,398 million in 2019 from $6,980 million in 2018. Gross premiums increased $250 million (11%) for other liability, $146 million (17%) for professional liability, $96 million (6%) for short-tail lines and $50 million (6%) for commercial auto, and decreased $124 million (9%) for workers' compensation.
Net premiums written were $6,863 million in 2019, an increase of 7% from $6,433 million in 2018. Ceded reinsurance premiums as a percentage of gross written premiums were 17% in both 2019 and 2018.
Premiums earned increased 4% to $6,633 million in 2019 from $6,372 million in 2018. Insurance premiums (including the impact of rate changes) are generally earned evenly over the policy term, and accordingly recent rate increases will be earned over the upcoming quarters. Premiums earned in 2019 are related to business written during both 2019 and 2018. Audit premiums were $199 million in 2019 compared with $192 million in 2018.
Net investment income decreased 4% to $646 million in 2019 from $674 million in 2018 primarily due to a $40 million decrease in investment funds, as well as a decrease in income from fixed maturity securities of $1 million and an increase in investment expenses of $1 million, partially offset by a $6 million increase in arbitrage trading account, an increase in real estate of $6 million, and a $2 million increase in equity securities. Investment funds are reported on a one quarter lag. The average annualized yield for fixed maturity securities was 3.4% in 2019 and 3.6% in 2018; accordingly, the decrease in fixed maturity securities income was mainly the result of lower interest rates. The effective duration of the fixed maturity portfolio was 2.8 years at both December 31, 2019 and 2018. The Company has maintained a shortened duration of its fixed maturity security portfolio. This has reduced the potential impact of mark-to-market adjustments on the portfolio and positioned the Company to react quickly to changes in the environment. Average invested assets, at cost (including cash and cash equivalents), were $19.1 billion in 2019 and $18.4 billion in 2018.
Insurance Service Fees. The Company earns fees from an insurance distribution business, a third-party administrator, and as a servicing carrier of workers' compensation assigned risk plans for certain states. Insurance service fees were $93 million in 2019 and $118 million in 2018. The decrease is primarily due to the sale of a third party administration business in the third quarter of 2018 and a reduction of assigned risk plan business.
Net Realized and Unrealized Gains on Investments. The Company buys and sells securities and other investment assets on a regular basis in order to maximize its total return on investments. Decisions to sell securities and other investment assets are based on management’s view of the underlying fundamentals of specific investments as well as management’s expectations regarding interest rates, credit spreads, currency values and general economic conditions. Effective January 1, 2018, the Company adopted accounting guidance that requires all equity investments with readily determinable fair values to be
measured at fair value with changes in the fair value recognized through net income (other than those equity securities accounted for under the equity method of accounting or those that result in consolidation of the investee). Net realized and unrealized gains on investments were $121 million in 2019 compared with $154 million in 2018. In 2019, the gains reflected net realized gains on investment sales of $36 million and increased by a change in unrealized gains on equity securities of $85 million. In 2018, the gains reflected net realized gains on investment sales of $480 million reduced by a change in unrealized gains on equity securities of $320 million as well as $6 million in OTTI.
A summary of loss ratios in 2019 compared with 2018 by business segment follows:
Reinsurance & Monoline Excess - The loss ratio of 61.5% in 2019 was 0.5 points higher than the loss ratio of 61.0% in 2018. Catastrophe losses were $22 million in 2019 compared with $30 million in 2018. Adverse prior year reserve development was $2 million in 2019 compared with favorable prior year reserve development of $20 million in 2018. The loss ratio excluding catastrophe losses and prior year reserve development decreased 1.5 points to 58.1% in 2019 from 59.6% in 2018.
Service expenses, which represent the costs associated with the fee-based businesses, decreased 14% to $101 million in 2019 from $118 million in 2018. The decrease is primarily due to the sale of a third party administration business in the third quarter of 2018 and a reduction of assigned risk plan business.
Net foreign currency (gains) losses result from transactions denominated in a currency other than an operating unit’s functional currency. Net foreign currency gains were $31 million in 2019 compared to gains of $27 million in 2018, mainly resulting from the continued strengthening of the U.S. dollar in the relation to the Argentine peso.
Other costs and expenses represent general and administrative expenses of the parent company and other expenses not allocated to business segments, including the cost of certain long-term incentive plans and new business ventures. Other costs and expenses increased to $201 million in 2019 from $193 million in 2018.
The Company has not provided U.S. deferred income taxes on the undistributed earnings of approximately $124 million of its non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the non-U.S. subsidiaries. In the future, if such earnings were distributed the Company projects that the incremental tax, if any, will be immaterial.
The Company reported net income of $641 million in 2018 compared to $549 million in 2017. The 17% increase in net income was primarily due to an after-tax increase in net investment income of $79 million, mainly driven by growth in the fixed maturity security portfolio, higher interest rates and an increase in investment funds, an after-tax increase in underwriting income of $72 million, a $34 million increase in after-tax foreign currency gains, an after-tax increase in income from non-insurance businesses of $6 million, and a $60 million decrease in tax expense primarily due to the reduction of the federal corporate tax rate from 35% to 21%, partially offset by a decrease in after-tax net investment gains of $145 million, an after-tax increase in interest expense of $8 million, an after-tax reduction in insurance service fee income of $4 million, and an after-tax increase in corporate expenses of $2 million. The number of weighted average diluted shares decreased slightly primarily due to share repurchases.
Premiums. Gross premiums written were $7,702 million in 2018, an increase of 3% from $7,477 million in 2017. The increase was due to growth in the Insurance segment of $281 million, partially offset by a decrease in the Reinsurance & Monoline Excess segment of $56 million. Approximately 78% of policies expiring in 2018 were renewed, and 79% of policies expiring in 2017 were renewed.
Average renewal premium rates (adjusted for change in exposures) increased 2.5% in 2018 and 0.9% in 2017.
Insurance gross premiums increased 4% to $6,980 million in 2018 from $6,699 million in 2017. Gross premiums increased $157 million (7%) for other liability, $87 million (12%) for professional liability, $64 million (4%) for short-tail lines and $54 million (7%) for commercial auto, and decreased $81 million (5%) for workers' compensation.
Net Realized and Unrealized Gains on Investments. The Company buys and sells securities and other investment assets on a regular basis in order to maximize its total return on investments. Decisions to sell securities and other investment assets are based on management’s view of the underlying fundamentals of specific investments as well as management’s expectations regarding interest rates, credit spreads, currency values and general economic conditions. Effective January 1, 2018, the Company adopted accounting guidance that requires all equity investments with readily determinable fair values to be measured at fair value with changes in the fair value recognized through net income (other than those equity securities accounted for under the equity method of accounting or those that result in consolidation of the investee). Net realized and unrealized gains on investments were $154 million in 2018 compared with $336 million in 2017. In 2018, the gains reflected net realized gains on investment sales of $480 million reduced by a change in unrealized gains on equity securities of $320
Revenues from Non-Insurance Businesses. Revenues from non-insurance businesses were derived from businesses engaged in the distribution of promotional merchandise, world-wide textile solutions, and aviation-related businesses that provide services to aviation markets, including (i) the distribution, manufacturing, repair and overhaul of aircraft parts and components, (ii) the sale of new and used aircraft, and (iii) avionics, fuel, maintenance, storage and charter services. Revenues from non-insurance businesses increased to $373 million in 2018 from $326 million in 2017, primarily due to the purchase of a business in the second half of 2018 and revenues from a textile business purchased in March 2017.
Losses and Loss Expenses. Losses and loss expenses decreased to $3,975 million in 2018 from $4,002 million in 2017. The consolidated loss ratio was 62.4% in 2018 and 63.4% in 2017. Catastrophe losses, net of reinsurance recoveries and reinstatement premiums, were $105 million in 2018 compared with $184 million in 2017. The more significant 2017 catastrophe losses largely related to hurricanes Harvey, Irma, and Maria, along with two earthquakes in Mexico. Favorable prior year reserve development (net of premium offsets) was $39 million in 2018 compared with $37 million in 2017. The loss ratio excluding catastrophe losses and prior year reserve development increased 0.2 points to 61.3% in 2018 from 61.1% in 2017.
Insurance - The loss ratio was 62.5% in both 2018 and 2017. Catastrophe losses were $76 million in 2018 compared with $107 million in 2017. Favorable prior year reserve development was $19 million in 2018 compared with $30 million in 2017. The loss ratio excluding catastrophe losses and prior year reserve development increased 0.4 points to 61.5% in 2018 from 61.1% in 2017.
Reinsurance & Monoline Excess - The loss ratio of 61.0% in 2018 was 9.0 points lower than the loss ratio of 70.0% in 2017. Catastrophe losses were $29 million in 2018 compared with $77 million in 2017. Favorable prior year reserve development was $20 million in 2018 compared with $7 million in 2017. The loss ratio excluding catastrophe losses and prior year reserve development decreased 1.1 points to 59.6% in 2018 from 60.7% in 2017.
Net foreign currency (gains) losses result from transactions denominated in a currency other than an operating unit’s functional currency. Net foreign currency gains were $27 million in 2018 compared to losses of $15 million in 2017, resulting from the strengthening U.S. dollar and the change of functional currency for the Company's Argentine operations to the U.S. dollar as of July 1, 2018. The Argentine economy was determined to be highly inflationary under GAAP requiring the change in functional currency beginning with the third quarter of 2018.
Income Taxes. The effective income tax rate was 20% in 2018 compared to 28% in 2017. The decrease in the effective tax rate in 2018 from 2017 was primarily due to the Tax Cuts and Jobs Act of 2017, which reduced the federal corporate tax rate from 35% to 21%.
The Company also attempts to maintain an appropriate relationship between the effective duration of the investment portfolio and the approximate duration of its liabilities (i.e., policy claims and debt obligations). The effective duration of the investment portfolio was 2.8 years at December 31, 2019 and 2018. The Company’s investment portfolio and investment-related assets as of December 31, 2019 were as follows:
portfolio is considered necessary to maintain an approximate matching of assets and liabilities as well as to adjust the portfolio as a result of changes in financial market conditions and tax considerations.
Equity Securities. Equity securities primarily represent investments in common and preferred stocks in companies with potential growth opportunities in different sectors, mainly in the financial institutions sector.
Cash Flow. Cash flow provided from operating activities increased to $1,144 million in 2019 from $620 million in 2018, primarily due to an increase in net premium receipts and the timing of loss and loss expense payments as well as payments to tax authorities.
Equity. The Company repurchased 269,072, 357,600, and 731,003 shares of its common stock in 2019, 2018 and 2017, respectively. The aggregate cost of the repurchases was $18 million in 2019, $25 million in 2018 and $48 million in 2017. In 2019, the Board declared regular quarterly cash dividends of $0.10 per share in the first quarter, and $0.11 per share in each of the remaining three quarters, plus additional special dividends in the respective amounts of $0.50 per share in the second quarter and $0.75 per share in the fourth quarter, for a total of $308 million in aggregate dividends in 2019. At December 31, 2019, total common stockholders’ equity was $6.1 billion, common shares outstanding were 183,411,907 and stockholders’ equity per outstanding share was $33.12.
Total Capital. Total capitalization (equity, debt and subordinated debentures) was $8.7 billion at December 31, 2019. The percentage of the Company’s capital attributable to senior notes, subordinated debentures and other debt was 30% at December 31, 2019 and 34% at December 31, 2018.
The Company files a consolidated income tax return in the U.S. and foreign tax returns in each of the countries in which it has overseas operations. At December 31, 2019, the Company had a gross deferred tax asset (net of valuation allowance) of $392 million (which primarily relates to loss and loss expense reserves and unearned premium reserves) and a gross deferred tax liability of $410 million (which primarily relates to deferred policy acquisition costs, unrealized investment gains and investment funds). The realization of the deferred tax asset is dependent upon the Company's ability to generate sufficient taxable income in future periods. Based on historical results and the prospects for future operations, management anticipates that it is more likely than not that future taxable income will be sufficient for the realization of this asset.
Following is a summary of earned premiums and loss and loss expenses ceded to reinsurers for each of the three years ended December 31, 2019:
Ceded earned premiums increased 7.5% in 2019 to $1,329 million. The ceded losses and loss expenses ratio decreased 4 points to 63% in 2019 from 67% in 2018.
The following table presents the credit quality of amounts due from reinsurers as of December 31, 2019. Amounts due from reinsurers are net of reserves for uncollectible reinsurance of $1 million in the aggregate.
Many states require licensed insurers that provide workers' compensation insurance to participate in programs that provide workers' compensation to employers that cannot procure coverage from an insurer on a voluntary basis. Insurers can fulfill this residual market obligation by participating in pools where results are shared by the participating companies. The Company acts as a servicing carrier for workers' compensation pools in certain states. As a servicing carrier, the Company writes residual market business directly and then cedes 100% of this business to the respective pool. As a servicing carrier, the Company receives fee income for its services. The Company does not retain underwriting risk, and credit risk is limited as ceded balances are jointly shared by all the pool members.
The Company utilizes letters of credit to back certain reinsurance payments and obligations. Outstanding letters of credit were $4 million as of December 31, 2019. The Company has made certain guarantees to state regulators that the statutory capital of certain subsidiaries will be maintained above certain minimum levels.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 20, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
As discussed in Notes 1 and 13 to the consolidated financial statements, the Company estimates the reserves for losses and loss expenses (reserves) using a variety of actuarial techniques and methods based on expected loss ratios, rate of
loss cost inflation, reported and paid loss emergence patterns, loss frequency and severity, and the loss reporting lag. Such amounts are adjusted for certain qualitative factors. The reserves as of December 31, 2019 were $12,583 million.
The primary procedures we performed to address the critical audit matter included the following. We tested certain internal controls over the Company’s reserving process, including controls over the Company’s process to develop the Company’s best estimate of reserves based on actuarial methodologies and assumptions employed by the Company’s actuaries. We involved actuarial professionals with specialized skills and knowledge, who assisted in:
Examining the Company’s actuarial methodologies for compliance with Actuarial Standards of Practice;
Evaluating the Company’s actuarial point estimate by examining the Company actuaries’ procedures, and certain key assumptions for the remaining operating units;
The consolidated financial statements, which include the accounts of W. R. Berkley Corporation and its subsidiaries (the "Company"), have been prepared on the basis of U.S. generally accepted accounting principles ("GAAP"). All significant intercompany transactions and balances have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the revenues and expenses reflected during the reporting period. The most significant items on our balance sheet that involve a greater degree of accounting estimates that are subject to change in the future are the valuation of investments, other-than-temporary impairments, reserves for losses and loss expenses and premium estimates. Actual results could differ from those estimates.
Fixed maturity securities that the Company purchased with the intent to sell in the near-term are classified as trading account securities and are reported at estimated fair value. Realized and unrealized gains and losses from trading activity are reported as net investment income and are recorded at the trade date. Short sales and short call options are presented as trading securities sold but not yet purchased. Unsettled trades and the net margin balances held by the clearing broker are presented as a trading account receivable from brokers and clearing organizations.
Investment funds are carried under the equity method of accounting. The Company's share of the earnings or losses of investment funds is primarily reported on a one-quarter lag in order to facilitate the timely completion of the Company's consolidated financial statements.
Real estate held for investment purposes is initially recorded at the purchase price, which is generally fair value, and is subsequently reported at cost less accumulated depreciation. Real estate taxes, interest and other costs incurred during
The Company presents both basic and diluted net income per share (“EPS”) amounts. Basic EPS is calculated by dividing net income by weighted average number of common shares outstanding during the year (including 7,575,168 common shares held in a grantor trust). The common shares held in the grantor trust are for delivery upon settlement of vested but mandatorily deferred restricted stock units ("RSUs"). Shares held by the grantor trust do not affect diluted shares outstanding since the shares deliverable under vested RSUs were already included in diluted shares outstanding. Diluted EPS is based upon the weighted average number of basic and common equivalent shares outstanding during the year and is calculated using the treasury stock method for stock incentive plans. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect.
Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's functional currency) are reported on the statements of income as other operating costs and expenses. Unrealized gains or losses resulting from translating the results of non-U.S. dollar denominated operations are reported in accumulated other comprehensive income. Revenues and expenses denominated in currencies other than U.S. dollars are generally translated at the weighted average exchange rate during the year. Assets and liabilities are translated at the rate of exchange in effect at the balance sheet date.
Property, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the estimated useful lives of the respective assets. Depreciation expense was $54 million, $54 million and $50 million for 2019, 2018 and 2017, respectively.
Interest payments were $160 million, $155 million and $145 million in 2019, 2018 and 2017, respectively. Income taxes paid were $125 million, $186 million and $207 million in 2019, 2018 and 2017, respectively. Other non-cash items include unrealized investment gains and losses. (See Note 10 of Notes to Consolidated Financial Statements.)
In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-02, Leases, which amends the accounting and disclosure guidance for leases. This guidance retains the two classifications of a lease, as either an operating or finance lease, both of which require lessees to recognize a right-of-use asset and a lease liability for leases with terms of more than 12 months. The right-of-use asset and the lease liability are determined based upon the present value of cash flows. Finance leases reflect the financial arrangement by recognizing interest expense on the lease liability separately from the amortization expense of the right-of-use asset. Operating leases recognize lease expense (with no separate recognition of interest expense) on a straight-line basis over the term of the lease. The accounting by lessors is not significantly changed by the updated guidance. The updated guidance was effective for reporting periods beginning after December 15, 2018. As permitted by the rules, the Company adopted the new guidance prospectively effective January 1, 2019. The Company elected to use the practical expedient permitted by the transition guidance which allowed companies to not reassess existing lease classifications for already effective leases. The adoption of this guidance resulted in the recognition of a right-of-use asset of $185 million and a lease liability of $215 million (prior to adoption the Company had a $30 million
All other accounting and reporting standards that became effective in 2019 were either not applicable to the Company or their adoption did not have a material impact on the Company.
(1) Gross unrealized gains (losses) for mortgage-backed securities include $314,347 and ($55,090) as of December 31, 2019 and 2018, respectively, related to the non-credit portion of OTTI recognized in other comprehensive income.
The amortized cost and fair value of fixed maturity securities at December 31, 2019, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers may have the right to call or prepay obligations.
The Company uses put options and call options in order to mitigate the impact of potential changes in market conditions on the merger arbitrage trading account. These options are reported at fair value. As of December 31, 2019, the fair value of long option contracts outstanding was $9 thousand (notional amount of $15.5 million) and the fair value of short option contracts outstanding was $56 thousand (notional amount of $17.1 million). Other than with respect to the use of these trading account securities, the Company does not make use of derivatives.
In 2019, properties in operation included a long-term ground lease in Washington, D.C., a hotel in Memphis, Tennessee, two office complexes in New York City, office buildings in West Palm Beach and Palm Beach, Florida, and an office building in London, U.K. Properties in operation are net of accumulated depreciation and amortization of $59,832,000 and $44,340,000 as of December 31, 2019 and 2018, respectively. Related depreciation expense was $15,033,000 and $20,644,000 for the years ended December 31, 2019 and 2018, respectively. Future minimum rental income expected on operating leases relating to properties in operation is $59,975,701 in 2020, $62,145,941 in 2021, $62,734,252 in 2022, $56,477,620 in 2023, $54,281,781 in 2024 and $573,636,251 thereafter.
Loans receivable in non-accrual status were $0.2 million and $1.2 million as of December 31, 2019 and 2018, respectively.
The real estate loans are secured by commercial real estate primarily located in New York. These loans generally earn interest at floating LIBOR-based interest rates and have maturities (inclusive of extension options) through August 2025. The commercial loans are with small business owners who have secured the related financing with the assets of the business. Commercial loans generally earn interest on a fixed basis and have varying maturities not exceeding 10 years.
In evaluating the real estate loans, the Company considers their credit quality indicators, including loan to value ratios, which compare the outstanding loan amount to the estimated value of the property, the borrower’s financial condition and performance with respect to loan terms, the position in the capital structure, the overall leverage in the capital structure and other market conditions. Based on these considerations, none of the real estate loans were considered to be impaired at December 31, 2019, and accordingly, the Company determined that a specific valuation allowance was not required.
For the year ended December 31, 2019, there were no OTTI recognized in earnings for fixed maturity securities. For the year ended December 31, 2018, there were $6 million of OTTI recognized on fixed maturity securities.
Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to the Company. The length of the loss reporting lag affects our ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags) as well as the amount of reserves needed for incurred but not reported losses (less IBNR is required for lines with short reporting lags). As a result, loss reserves for lines with short reporting lags are likely to have less variation from initial loss estimates. For lines with short reporting lags, which include commercial automobile, primary workers’ compensation, other liability (claims-made) and property business, the key assumption is the loss emergence pattern used to project ultimate loss estimates from known losses paid or reported to date. For lines of business with long reporting lags, which include other liability (occurrence), products liability, excess workers’ compensation and liability reinsurance, the key assumption is the expected loss ratio since there is often little paid or incurred loss data to consider. Historically, the Company has experienced less variation from its initial loss estimates for lines of businesses with short reporting lags than for lines of business with long reporting lags.
The reconciliation of the net incurred and paid claims development tables to the reserves for losses and loss expenses in the consolidated balance sheet is as follows:
The change in estimates for claims occurring in prior years is net of loss reserve discount. On an undiscounted basis, the estimates for claims occurring in prior years increased by $19 million in 2019, and decreased $4 million and $32 million in 2018 and 2017, respectively.
For professional liability business, the unfavorable development was driven mainly by an increase in the number of large losses reported in the lawyers professional liability and directors and officers (“D&O”) liability lines of business. Many of the lawyers large losses involved claims made against insured law firms relating to work performed on matters stemming from the 2008 financial crisis. These claims affected mainly accident years 2013 through 2016. In addition, for both of these lines of business, we
Reinsurance & Monoline Excess - Reserves for the Reinsurance & Monoline Excess segment developed favorably by $20 million in 2018. The favorable development was primarily due to excess workers’ compensation business, and was spread across many accident years, including years prior to 2009. This favorable excess workers’ compensation development was partially offset by unfavorable development on U.S. casualty facultative assumed business from accident years 2009 and prior related to construction projects.
many accident years, including years prior to 2008. The favorable excess workers’ compensation development resulted due to the same causes discussed above for workers’ compensation in the Insurance segment.
The Company’s net reserves for losses and loss expenses relating to asbestos and environmental claims on policies written before adoption of the absolute exclusion was $24 million at December 31, 2019 and $28 million at December 31, 2018. The estimation of these liabilities is subject to significantly greater than normal variation and uncertainty because it is difficult to make an actuarial estimate of these liabilities due to the absence of a generally accepted actuarial methodology for these exposures and the potential effect of significant unresolved legal matters, including coverage issues, as well as the cost of litigating the legal issues. Additionally, the determination of ultimate damages and the final allocation of such damages to financially responsible parties are highly uncertain.
Discounting - The Company discounts its liabilities for certain workers’ compensation reserves. The amount of workers’ compensation reserves that were discounted was $1,731 million and $1,793 million at December 31, 2019 and 2018, respectively. The aggregate net discount for those reserves, after reflecting the effects of ceded reinsurance, was $530 million and $563 million at December 31, 2019 and 2018, respectively. At December 31, 2019, discount rates by year ranged from 2.0% to 6.5%, with a weighted average discount rate of 3.7%.
Indebtedness consisted of the following as of December 31, 2019 (the difference between the face value and the carrying value is unamortized discount and debt issuance costs):
A reconciliation of the income tax expense and the amounts computed by applying the Federal and foreign income tax rate of 21% for 2019 and 2018 and 35% for 2017 to pre-tax income are as follows:
At December 31, 2019 and 2018, the tax effects of differences that give rise to significant portions of the deferred tax asset and deferred tax liability are as follows:
The Tax Cuts and Jobs Act of 2017 (the "Tax Act") provided for a reduction of the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. The U.S. tax law requires insurance reserves to be discounted for tax purposes. The Tax Act modified this computation. At the end of 2018, the IRS issued revised discount factors to be applied to the 2017 reserves. During 2019, the IRS updated the revised discount factors. This modified the increase in the beginning of year 2018 deferred tax asset for loss reserve discounting to $40 million. Under the related transition rule, a deferred tax liability was established which will be included in taxable income over eight years beginning in 2018.
As described in Note 1, the Company prospectively adopted ASU 2016-02, Leases, effective January 1, 2019, which requires lessees to recognize a right-of-use asset and a lease liability for leases with terms of more than 12 months on the balance sheet. All leases disclosed within this note are classified as operating leases. Recognized right-of-use asset and lease liability are reported within other assets and other liabilities, respectively, in the consolidated balance sheet. Lease expense is reported in other operating costs and expenses in the consolidated statement of income and accounted for on a straight-line basis over the lease term.
To determine the discount rate used to calculate present value of future minimum lease payments, the Company uses its incremental borrowing rate during the lease commencement period in line with the respective lease duration. In certain cases, the Company has the option to renew the lease. Lease renewal future payments are included in the present value of the future minimum lease payments when the Company determines it is reasonably certain to renew.
The Company and its subsidiaries have profit sharing plans in which substantially all employees participate. The plans provide for minimum annual contributions of 5% of eligible compensation; contributions above the minimum are discretionary and vary with each participating operating unit's profitability. Employees become eligible to participate in the plan on the first day of the calendar quarter following the first full calendar quarter after the employee's date of hire provided the employee has completed 250 hours of service during the calendar quarter. The plans provide that 40% of the contributions vest immediately and that the remaining 60% vest at varying percentages based upon years of service. Profit sharing expense was $47 million, $42 million and $42 million in 2019, 2018 and 2017, respectively.
Insurance - predominantly commercial insurance business, including excess and surplus lines, admitted lines and specialty personal lines throughout the United States, as well as insurance business in the United Kingdom, Continental Europe, South America, Canada, Mexico, Scandinavia, Asia and Australia.
Reinsurance & Monoline Excess - reinsurance business on a facultative and treaty basis, primarily in the United States, United Kingdom, Continental Europe, Australia, the Asia-Pacific region and South Africa, as well as operations that solely retain risk on an excess basis.
(2) Revenues for Insurance includes $725.4 million, $714.2 million, and $688.2 million in 2019, 2018, and 2017, respectively, from foreign countries. Revenues for Reinsurance & Monoline Excess includes $249.6 million, $228.1 million, and $201.3 million in 2019, 2018 and 2017, respectively, from foreign countries.