The following is a comparison of selected data from our results of operations:
In presenting our results in the following discussion and analysis of our results of operations, we have included certain non-generally accepted accounting principles ("non-GAAP") financial measures within the meaning of Regulation G as promulgated by the SEC. We believe that these non-GAAP measures, specifically the current accident year non-catastrophe loss, expense and combined ratios, which may be defined differently by other companies, better explain our results of operations in a manner that allows for a more complete understanding of the underlying trends in our business. However, these measures should not be viewed as a substitute for those determined in accordance with United States generally accepted accounting principles ("GAAP"). Reconciliations of these financial measures to their most directly comparable GAAP measures are included in the table below.
(2) Catastrophe losses' percentage point impact are calculated as the difference between the reported combined ratio and the combined ratio excluding incurred catastrophe losses and associated reinstatement and other catastrophe-related premium adjustments.
In accordance with this accounting standard, for the year ended December 31, 2018, we recognized the change in the fair value of our equity securities as a pre-tax loss of $105.1 million. This amount is included as a component of net realized investment losses in our Consolidated Statements of Income. Amounts for the years ended December 31, 2017 and 2016 are not presented as a component of net income, as ASU 2016-01 was required to be adopted on a prospective basis.
As part of the full integration of the reinsurance business of Ariel Re, beginning in 2018 we changed the capital structure supporting that business by introducing certain third party trade capital to participate in the exposures we underwrite. This trade capital receives a corresponding proportion of the gross written premiums. As such, this structure has the effect of reducing the gross written premiums reported in our financial statements. In exchange, we receive certain remuneration for generating this business and for the underlying underwriting performance. There was no such structure for our Ariel Re business in 2017.
The decrease in consolidated net investment income for the year ended December 31, 2018 as compared to the same period in 2017 was primarily due to a $29.7 million decrease in the net investment income of our alternative investment portfolio, partially offset by a $22.8 million increase in the net investment income of our core portfolio. The decline in the alternative investment portfolio was due to the volatility experienced in the securities markets primarily during the fourth quarter of 2018, as well as the impact of a $12.2 million pre-tax net investment gain recognized in 2017 related to a sale process initiated by an equity investee. The increase in net investment income from our core portfolio was primarily due to higher asset balances and increased investment yields.
Consolidated losses and loss adjustment expenses were $1,040.8 million, $1,050.2 million and $810.1 million for the years ended December 31, 2018, 2017 and 2016, respectively. The consolidated loss ratio for the year ended December 31, 2018 was 60.1%, compared to 66.8% for the same period in 2017. This 6.7 percentage point decrease in the loss ratio was primarily due to a 5.4 percentage point favorable impact related to lower catastrophe losses. The current accident year non-catastrophe loss ratio improved 0.8 percentage points during the year ended December 31, 2018, compared to the same period in 2017. In connection with the acquisition and integration of Ariel Re, we made a number of one-time catastrophe and risk management reinsurance purchases in 2017. These 2017 purchases reduced earned premiums by $20.8 million, resulting in a 0.7 percentage point increase in the 2017 loss ratio. Partially offsetting this improvement to the current accident year non-catastrophe loss ratio were a number of discrete marine and energy losses within our International Operations segment, concentrated in the fourth quarter of 2018. We also experienced a 0.5 percentage point favorable impact from the increase in net favorable prior-year reserve development for the year ended December 31, 2018, compared to the same period in 2017.
prior accident year loss reserves, primarily attributable to favorable development in our commercial automobile, property reinsurance, surety and commercial multiple peril lines, partially offset by unfavorable development in our general liability line.
Consolidated gross reserves for loss and loss adjustment expenses were $4,654.6 million (including $226.2 million of reserves attributable to our Syndicate 1200 and 1910 trade capital providers), $4,201.0 million (including $226.8 million of reserves attributable to Syndicate 1200’s trade capital providers) and $3,350.8 million (including $156.1 million of reserves attributable to Syndicate 1200’s trade capital providers) as of December 31, 2018, 2017 and 2016, respectively. Management has recorded its best estimate of loss reserves at each date based on current known facts and circumstances. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development, favorable or unfavorable, will not occur.
The expense ratio for the year ended December 31, 2017 as compared to the same period in 2016 was negatively impacted by the aforementioned one-time catastrophe and risk management reinsurance premium purchases and additional group reinsurance contracts purchased in connection with risk management activities following the acquisition of Ariel Re. These adjustments increased the expense ratio by 1.0 percentage point. The remaining increase in the expense ratio was primarily attributable to increased information technology costs and higher personnel expenses in our strategic growth units.
Consolidated foreign currency exchange gains were $0.1 million for the year ended December 31, 2018 as compared to losses of $6.3 million and gains of $4.5 million for the years ended December 31, 2017 and 2016, respectively. The changes in the foreign currency exchange gains/losses were due to fluctuations of the U.S. Dollar, on a weighted average basis, against the currencies in which we transact our business.
For the year ended December 31, 2018, the small foreign currency exchange gain was driven by the U.S. Dollar strengthening against the British Pound. For the year ended December 31, 2017, the foreign currency exchange losses were driven by the U.S. Dollar weakening against the British Pound, the Euro, the Canadian Dollar and the Australian Dollar. For the year ended December 31, 2016, the foreign currency exchange gain was primarily due to the U.S. Dollar strengthening against the British Pound and the Euro.
The consolidated provision for income taxes was $4.1 million for the year ended December 31, 2018, compared to an income tax benefit of $10.4 million for the year ended December 31, 2017, and an income tax provision of $35.2 million for the year ended December 31, 2016. The consolidated income tax provision represents the income tax expense or benefit associated with our operations based on the tax laws of the jurisdictions in which we operate. Therefore, the consolidated provision for income taxes represents taxes on net income for our Belgium, Brazil, Ireland, Italy, Malta, Switzerland, United Kingdom and United States operations. The consolidated effective tax rates were 6.1%, -26.1% and 19.4% for the years ended December 31, 2018, 2017 and 2016, respectively.
The decrease in the effective tax rate for the year ended December 31, 2017 as compared to the same period in 2016 was primarily related to the revaluation of our net deferred tax liability due to the reduction of the U.S. corporate statutory income tax rate from 35% to 21% (primarily related to the unrealized gains on our investment portfolio) benefiting our 2017 tax provision by $20.2 million. This benefit, recognized in the fourth quarter of 2017, primarily offset the year-to-date U.S. tax expense. The remaining decrease in our effective tax rate was primarily attributable to a higher pretax loss from our United Kingdom operations in 2017, with an associated income tax benefit of $10.3 million for the year ended December 31, 2017.
We are primarily engaged in writing property and casualty insurance and reinsurance. We have two ongoing reporting segments: U.S. Operations and International Operations. Additionally, we have a Run-off Lines segment for products that we no longer underwrite.
We consider many factors, including the nature of each segment’s insurance and reinsurance products, production sources, distribution strategies and regulatory environment, in determining how to aggregate reporting segments.
Specialty includes niche insurance coverages including marine & energy, accident & health and surety product offerings.
(1) For purposes of calculating the percentage points impact on the loss, expense and combined ratios, earned premiums were adjusted to exclude outward reinstatement and other catastrophe-related premium adjustments of $7.7 million and $5.1 million for the years ended December 31, 2018 and 2017, respectively.
following the acquisition of Ariel Re which reduced net earned premiums by $4.1 million, all within our Property lines. Underwriting actions taken in certain programs to optimize results also account for the reduction in earned premiums during the year ended December 31, 2017 as compared to the same period in 2016.
The increase in the loss ratio for the year ended December 31, 2018 as compared to the same period in 2017 was primarily due to a decline in net favorable loss reserve development on prior accident years, partially offset by lower catastrophe losses in 2018 as compared to 2017. The increase in the loss ratio for the year ended December 31, 2017 compared to the same period in 2016 was primarily due to increased non-catastrophe current accident year property losses in 2017.
Included in losses and loss adjustment expense for the year ended December 31, 2018 was $15.6 million in catastrophe losses from the Woolsey and Camp California wildfires, Hurricane Florence, and other smaller storms in the United States. Offsetting the catastrophe losses was $20.8 million of net favorable loss reserve development on prior accident years which was primarily concentrated in our general liability and surety lines, partially offset by unfavorable loss reserve development on prior accident years in commercial multi-peril lines.
Fee and other income, and the associated fee and other expense, decreased for the year ended December 31, 2018 as compared to the same period in 2017 primarily due to the result of a transaction that was executed in the third quarter of 2017 to transfer to a third party the distribution rights and operations of certain business managed on behalf of unaffiliated insurance companies. The fee income and expense related to this program were recorded as part of our fee and other income and expense, respectively.
Gross written and earned premiums by our four primary insurance lines were as follows:
Included in losses and loss adjustment expense for the year ended December 31, 2018 was $37.3 million in catastrophe losses, primarily attributable to Hurricanes Florence and Michael, the Woolsey and Camp California wildfires, and other storms primarily outside the United States. Losses and loss adjustment expenses also included $9.5 million of net favorable loss reserve development on prior accident years, concentrated in the specialty and liability lines. We also experienced a number of discrete non-catastrophe current accident year marine and energy losses in 2018.
The slight decrease in fee and other expenses for the year ended December 31, 2018 as compared to the same period in 2017 is primarily due to lower costs related to outside services and employee benefits.
Fee and other income increased for the year ended December 31, 2017 as compared to the same period ended 2016 primarily due to fee income earned by Syndicate 1910, as well as additional fee income earned by Syndicate 1200 due to the increase in ownership participation by third party capital providers in 2017.
The increase in fee and other expenses for the year ended December 31, 2017 as compared to the same period in 2016 is primarily due to the costs incurred in 2017 associated with the startup of our digital affinity group business. In addition, the reduction to profit commissions payable to trade capital providers were less than in 2017 when compared to the reductions in 2016.
Earned premiums for the years ended December 31, 2018, 2017 and 2016 were attributable to final audits, reinstatement premiums and other adjustments on policies previously underwritten.
Underwriting, acquisition and insurance expenses for the Run-off Lines segment consists primarily of administrative expenses. Underwriting expense for the year ended December 31, 2018 was favorably impacted by decreased overhead expenses. Underwriting expense for the year ended December 31, 2017 was unfavorably impacted by increased overhead expenses and policyholder dividends Underwriting expense for the year ended December 31, 2016 was favorably impacted by reduced policyholder dividends and outside services fees, as well as a reduction in bad debt expenses due to the collection of a premiums receivable balance that was previously written off.
Under certain insurance programs (i.e., large deductible programs and surety bonds) and various reinsurance agreements, collateral and LOCs are held for our benefit to secure performance of insureds and reinsurers in meeting their obligations. At December 31, 2018, the amount of such collateral and LOCs held under insurance and reinsurance agreements was $754.7 million and $944.0 million, respectively. Collateral can also be provided in the form of trust accounts. As we are the beneficiary of these trust accounts only to secure future performance, these amounts are not reflected in our Consolidated Balance Sheets. Collateral provided by an insured or reinsurer may exceed or fall below the amount of their total outstanding obligation.
In December 2018, Argo Re paid a cash dividend of $36.5 million to Argo Group which was used to repay intercompany balances related primarily to dividend payments, interest payments and other corporate expenses.
During 2019, Argo Group U.S., Inc. may be permitted to receive dividends from its subsidiaries as follows: Argonaut Insurance Company - $89.6 million and Rockwood - $12.6 million. Business and regulatory considerations may impact the amount of dividends actually paid and prior approval of dividend payments may be required.
Revolving Credit Facility and Term Loan. On November 2, 2018, each of Argo Group, Argo Group U.S., Inc., Argo International Holdings Limited, and Argo Underwriting Agency Limited (the “Borrowers”) entered into a anew $325 million credit agreement (the "New Credit Agreement") with JPMorgan Chase Bank, N.A., as administrative agent. The New Credit Agreement replaced the prior $325 million Credit Agreement (the "Prior Agreement"), dated as of March 3, 2017. In connection with the consummation of the New Credit Agreement, Argo Group International Holdings, Ltd. borrowed $125 million as a term loan due on November 2, 2021, which amount was used on November 2, 2018 to pay off in its entirety the $125 million of borrowings previously outstanding under the Prior Agreement. In addition, the New Credit Agreement provides for a $200 million revolving credit facility, and the commitments thereunder shall expire on November 2, 2023 unless extended in accordance with the terms of the New Credit Agreement. At December 31, 2018, the $125.0 million drawn on this term loan remained outstanding. The term loan bears interest based on a variable rate, which resets and is payable based on reset options we select pursuant to the terms of the Credit Agreement. As of December 31, 2018, the interest rate on this debt was equal to the three-month LIBOR (2.61% at December 31, 2018) plus 125 basis points, or 3.86%.
Included in the New Credit Agreement is a provision that allows up to $200.0 million of the revolving credit facility to be used for letters of credit (“LOCs”), subject to availability. As of December 31, 2018, there were no borrowings outstanding and $0.5 million in LOCs against the revolving credit facility.
Senior Notes. In September 2012, Argo Group (the “Parent Guarantor”), through its subsidiary Argo Group U.S. (the “Subsidiary Issuer”), issued $143,750,000 aggregate principal amount of the Subsidiary Issuer’s 6.5% Senior Notes due September 15, 2042 (the “Notes”). The Notes are unsecured and unsubordinated obligations of the Subsidiary Issuer and rank equally in right of payment with all of the Subsidiary Issuer’s other unsecured and unsubordinated debt. The Notes are guaranteed on a full and unconditional senior unsecured
basis by the Parent Guarantor. The Notes may be redeemed, for cash, in whole or in part, on or after September 15, 2017, at the Subsidiary Issuer’s option, at any time and from time to time, prior to maturity at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued but unpaid interest on the principal amount being redeemed to, but not including, the redemption date.
Floating Rate Loan Stock. We assumed debt through the acquisition of Syndicate 1200. These notes are unsecured. All are redeemable subject to certain terms and conditions at a price up to 100% of the principal plus accrued and unpaid interest. Interest on the U.S. Dollar and Euro notes is due semiannually and quarterly, respectively. A summary of the notes outstanding at December 31, 2018 is presented below:
Letter of Credit Facilities. Argo Re may be required to secure its obligations under various reinsurance contracts in certain circumstances. In order satisfy these requirements, Argo Re has entered into two secured, bilateral committed letter of credit (“LOC”) facilities with commercial banks and generally uses these facilities to issue LOCs in support of non-admitted reinsurance obligations in the U.S. and other jurisdictions. These facilities have a term of one year and include customary conditions and event of default provisions. The availability of letters of credit under these secured facilities are subject to a borrowing base requirement, determined on the basis of specified percentages of the market value of eligible categories of securities pledged to the lender. On December 31, 2018 these committed letter of credit facilities totaled $210 million.
On December 31, 2018, LOCs totaling $99.7 million were outstanding, of which $80.7 million were issued against the secured bilateral LOC facilities and $19.0 million were issued by a commercial bank on an uncommitted basis. Collateral with a market value of $120.9 million was pledged to these banks as security against these LOCs.
Preferred Stock. Throughout 2018, 2017 and 2016, we had no preferred shares outstanding.
On May 3, 2016, our Board of Directors declared a 10% stock dividend, payable on June 15, 2016, to shareholders of record at the close of business on June 1, 2016. As a result of the stock dividend, 2,735,542 additional shares were issued. Cash was paid in lieu of fractional shares of our common shares. All references to share and per share amounts in this document and related disclosures have been adjusted to reflect the stock dividend for all periods presented.
Our estimated contractual obligations and commitments as of December 31, 2018 were as follows:
(3) Interest only on Floating Rate Loan Stock through 2034. Interest calculated based on the rate in effect at December 31, 2018. Principal due beginning November 2034.
(4) Interest only on Term Loan through 2021. Interest calculated based on the rate in effect at December 31, 2018. Principal due November 2021.
(7) Multi-year contract’s base terms, as reflected in the above table, include premium per annum of $26.5 million during the coverage period of January 1, 2017 to December 31, 2020.
Following is a summary of gross and net loss reserves we recorded by line of business:
condition, results of operations and cash flows. Any adjustments to loss reserves are reflected in the results for the year during which the adjustments are made.
potential for an environmental or asbestos claim to involve many insurance providers over many policy periods;
uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
result in higher estimates for medical costs. But in the workers compensation context, the availability of that same medical procedure may enable workers to return to work more quickly, thereby lowering estimates for indemnity costs for that line of business. As a result, it usually is not possible to identify and measure the impact that a change in one discrete risk factor may have or construct a meaningful sensitivity expectation around it. We do not make explicit estimates of the impact on loss reserve estimates for the assumptions related to the risk factors described below.
Changes in the propensity to sue, in general and with specificity to particular issues;
Changes in the interpretations and processes of the workers compensation commissions’ oversight of claim;
Changes in the cost of medical treatments, including prescription drugs, and underlying fee schedules;
Recorded gross reserves for workers compensation were $581.9 million as of December 31, 2018. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately 55% of the workers compensation net reserves are related to future
Recorded gross reserves for our Lloyd’s Syndicate 1200 business were $825.6 million as of December 31, 2018. Estimation of our international liability reserves are subject to late emergence and mix shifts between smaller, more routine claims and larger, more complex claims. Our international property reserves are analyzed by the characteristics of the underlying exposures. Property loss reserves are characterized by relatively short periods between occurrence, reporting, determination of coverage and ultimate claims settlement. These property loss reserves tend to be the most predictable. Catastrophic loss reserves tend to exhibit more volatility due to the nature of the underlying loss event which may cause delays and complexity in estimating ultimate loss exposure.
With respect to asbestos and environmental general liability losses, we wrote several different categories of insurance contracts that may cover asbestos and environmental claims. First, we wrote primary policies providing the first layer of coverage in an insured’s general liability insurance program. Second, we wrote excess policies providing higher layers of general liability insurance coverage for losses that exhaust the limits of underlying coverage. Third, we acted as a reinsurer assuming a portion of those risks from other insurers underwriting primary, excess and reinsurance coverage. Fourth, we participated in the London Market, underwriting both direct insurance and assumed reinsurance business. With regard to both environmental and asbestos claims, significant uncertainty limits the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses. Traditional actuarial reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in a state of continued uncertainty. The degree of variability of reserve estimates for these types of exposures is significantly greater than for other more traditional general liability exposures, and as such, we believe there is a high degree of uncertainty inherent in the estimation of asbestos and environmental loss reserves.
uncertainties, further developments could cause us to change our estimates and ranges of our asbestos and environmental reserves, and the effect of these changes could be material to our consolidated operating results, financial condition and liquidity.
After reviewing the output from various loss reserving methodologies, we select our best estimate of reserves. We believe that the aggregate loss reserves at December 31, 2018 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. As of December 31, 2018, we recorded gross loss reserves of $4,654.6 million and loss reserves net of reinsurance of $2,562.9 million. Although our financial reports reflect our best estimate of reserves, it is unlikely that the final amount paid will exactly equal our best estimate. In order to provide an indication of the variability in loss reserve estimates, we develop reserve ranges by evaluating the variability implied by the results of the various methods and impact of changing the assumptions and factors used in the loss reserving process.
We estimate our range of reserves, net of reinsurance, at approximately $2,365.0 million to $2,845.0 million as of December 31, 2018. In determining this range, we evaluated the variability of the loss reserves for each of our major operating segments, comprising both ongoing operations and run-off businesses. Our estimated range does not make a specific provision for sources of unknown or unanticipated correlated events such as potential sources of liability not anticipated at the time coverage was afforded, such as asbestos. These events in combination with other events which may not be contemplated by management in developing our range may cause reserves to develop either more or less favorably than indicated by assumptions that we consider reasonable. This means that the range of reserve values does not represent the range of all possible favorable or unfavorable reserve outcomes, and actual ultimate paid losses may fall outside this range. No one risk factor has been isolated for the purpose of performing a sensitivity or variability analysis on that particular risk factor.
Our investments in fixed maturities and stocks are classified as available-for-sale and reported at fair value under GAAP. Changes in the fair value of investments classified as available-for-sale are not recognized in income during the period, but rather are recognized as a separate component of shareholders’ equity until realized. Fair values of these investments are estimated using prices obtained from third-party pricing services, where available. For securities where we are unable to obtain fair values from a pricing service or broker, fair values are estimated using information obtained from investment advisors. Management performed several processes to ascertain the reasonableness of investment values included in our consolidated financial statements at December 31, 2018, including i) obtaining and reviewing internal control reports for our accounting service providers that obtain fair values from third-party pricing services, ii) discussing with our investment managers their process for reviewing and validating pricing obtained from outside services and obtained values for all securities from our investment managers and iii) comparing the security pricing received from the investment managers with the prices used in our consolidated financial statements and obtained additional information for variances that exceeded a certain threshold. As of December 31, 2018, investments classified as available-for-sale for which we did not receive a fair value from a pricing service or broker accounted for less than 1% of our investment portfolio. The actual value at which such securities could be sold or settled with a willing buyer or seller may differ from such estimated fair values depending on a number of factors including, but not limited to, current and future economic conditions, the quantity sold or settled, the presence of an active market and the availability of a willing buyer or seller. Our investments in hedge and private equity funds and other private equity direct investments are accounted for under the equity method of accounting, with changes in the value of investments recognized in net investment income during the period. We have one available-for-sale private equity investment with changes in the value of investment recognized as a separate component of shareholders’ equity. We also have three small private equity investments accounted for at cost.
projecting future cash flows of the securities. Loss frequency is measured as the credit default rate, which includes such factors as loan-to-value ratios and credit scores of borrowers. Loss severity includes such factors as trends in overall housing prices and house prices that are obtained at foreclosure. Effective January 1, 2018, the Company adopted ASU 2016-1. As a result, all changes in the fair value of equity securities, whether temporary or other-than-temporary, are recognized in net realized investment (losses) gains in the Consolidated Statement of Income. For the years ended December 31, 2018, 2017 and 2016, we recorded $7.6 million, $2.5 million and $10.2 million, respectively, of realized losses due to the recognition of other-than-temporary impairments.
The evaluation of the recoverability of our gross deferred tax asset and the need for a valuation allowance requires us to weigh all positive and negative evidence to reach a conclusion that it is more likely than not that all or some portion of the net deferred tax asset will not be realized. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed. At each balance sheet date, management assesses the need to establish a valuation allowance that reduces deferred tax assets when it is more likely than not that all, or some portion, of the deferred tax assets will not be realized. The valuation allowance is based on all available information including projections of future taxable income from each tax-paying component in each tax jurisdiction, principally derived from business plans and available tax planning strategies. If our assumptions and estimates that resulted in our forecast of future taxable income for each tax-paying component prove to be incorrect, an additional valuation allowance could become necessary, which could have a material adverse effect on our financial condition and results of operations.
For the years ended December 31, 2018, 2017 and 2016, all of our reporting units passed the impairment test. As noted above, we have elected to make the first day of the fourth quarter the annual impairment assessment date for goodwill and other indefinite-lived intangible assets. An impairment analysis subsequent to this date has not been performed as we believe that no additional indicators of impairment have arisen, such as significant additional pricing competition, unexpected significant declines in operating results, divestiture of a significant component of the business or further significant decline in market capitalization.
We evaluated our definite lived intangibles for indicators of impairment. If indicators of impairment had been identified, we would have been required to test definite lived intangible assets for impairment. As of October 1, 2018, the testing date, no indicators of impairment