W. R. Berkley and its subsidiaries own or lease office buildings or office space suitable to conduct their operations. At December 31, 2012, the Company had aggregate office space of 3,753,361 square feet, of which 1,122,542 were owned and 2,630,819 were leased.
An important part of our strategy is to form new operating units to capitalize on various business opportunities, with 23 of our 48 units formed since 2006. These newer units are focused on important parts of the economy in the U.S., including healthcare, energy and agriculture, and on growing international markets, including Scandinavia, Australia, the Asia-Pacific region and South America. As a result, our international operations have become an increasingly important part of our business.
The profitability of the Company’s insurance business is affected primarily by the adequacy of premium rates. The ultimate adequacy of premium rates is not known with certainty at the time an insurance policy is issued because premiums are determined before claims are reported. The ultimate adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural and other disasters, regulatory measures and court decisions that define and change the extent of coverage and the effects of economic inflation on the amount of compensation for injuries or losses. General insurance prices are also influenced by available insurance capacity, i.e., the level of policyholders’ surplus employed in the industry, and the industry’s willingness to deploy that capital.
The Company’s profitability is also affected by its investment income and investment gains. The Company’s invested assets, which are derived from its own capital and cash flow from its insurance business, are invested principally in fixed maturity securities. The return on fixed maturity securities is affected primarily by general interest rates, which are at historically low levels, as well as the credit quality and duration of the securities. The Company also invests in equity securities, merger arbitrage, private equity investments, investment funds and real estate. The Company's investments in investment funds have experienced, and the Company expects to continue to experience, greater fluctuations in investment income.
In general, when a claim is reported, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment based upon known information about the claim at that time. The estimate represents an informed judgment based on general reserving practices and reflects the experience and knowledge of the claims personnel regarding the nature and value of the specific type of claim. Reserves are also established on an aggregate basis to provide for losses incurred but
not reported (“IBNR”) to the insurer, potential inadequacy of case reserves and the estimated expenses of settling claims, including legal and other fees and general expenses of administrating the claims adjustment process. Reserves are established based upon the then current legal interpretation of coverage provided.
The key assumptions used in calculating the most recent estimate of the loss reserves are reviewed each quarter and adjusted, to the extent necessary, to reflect historical changes, current trends and other factors observed. If the actual level of loss frequency and severity are higher or lower than expected, the ultimate losses will be different than management’s estimate. The following table reflects the impact of changes (which could be favorable or unfavorable) in frequency and severity, relative to our assumptions, on our loss estimate for claims occurring in 2012 (dollars in thousands):
Our net reserves for losses and loss expenses of approximately $8.4 billion as of December 31, 2012 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.
Information received from ceding companies is used to set initial expected loss ratios, to establish case reserves and to estimate reserves for incurred but not reported losses on assumed reinsurance business. This information, which is generally provided to the Company through reinsurance intermediaries, is gathered by the Company through the underwriting process and from periodic claim reports and other correspondence with ceding companies. The Company performs underwriting and claim audits of selected ceding companies to determine the accuracy and completeness of information provided to the Company. The information received from the ceding companies is supplemented by the Company’s own loss development experience with similar lines of business as well as industry loss trends and loss development benchmarks.
Following is a summary of the Company’s reserves for losses and loss expenses by business segment as of December 31, 2012 and 2011:
Assumed Reinsurance Premiums. The Company estimates the amount of assumed reinsurance premiums that it will receive under treaty reinsurance agreements at the inception of the contracts. These premium estimates are revised as the actual amount of assumed premiums is reported to the Company by the ceding companies. As estimates of assumed premiums are made or revised, the related amount of earned premiums, commissions and incurred losses associated with those premiums are
A summary of the Company’s non-investment grade fixed maturity securities that were in an unrealized loss position at December 31, 2012 is presented in the table below.
Loans Receivable - The Company monitors the performance of its loans receivable, including current market conditions for each loan and the ability to collect principal and interest. For loans where the Company determines it is probable that the contractual terms will not be met, an analysis is performed and a valuation reserve is established, if necessary, with a charge to earnings. Loans receivable are reported net of a valuation reserve of $6 million and $20 million at December 31, 2012 and 2011, respectively.
The following is a summary of pricing sources for the Company's fixed maturity securities available for sale as of December 31, 2012:
Independent pricing services - The vast majority 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, 2012, 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.
Results of Operations for the Years Ended December 31, 2012 and 2011
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, 2012 and 2011. 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, 2012 and 2011.
The Company reported net income of $511 million in 2012 compared to $391 million in 2011. The increase in net income was primarily due to an increase in after-tax net investment gains of $55 million, an increase in after-tax underwriting income of $44 million and an increase in after-tax net investment income of $36 million. The number of weighted average diluted shares decreased as a result of the Company’s repurchases of its common stock in 2012 and 2011.
Specialty premiums increased 14% to $2,071 million in 2012 from $1,818 million in 2011, primarily due to increased business in the energy and environmental markets. Gross premiums increased $89 million (16%) for other liability, $56 million (15%) for property lines, $46 million (32%) for workers' compensation, $31 million (10%) for professional liability, $15 million (9%) for commercial automobile, $9 million (9%) for products liability and $7 million for other lines.
International gross premiums increased 22% to $1,010 million in 2012 from $829 million in 2011. The increase was primarily due to an increase in business written by our Lloyd’s operation, and by our businesses in Australia, Germany and Norway. Gross premiums increased $50 million (56%) for marine, $42 million (38%) for casualty reinsurance, $29 million (25%) for property, $20 million (54%) for property reinsurance, $8 million (17%) for accident and health and $32 million (7%) for other lines.
Revenues from Wholly-Owned Investees. Revenues from wholly-owned investees were derived from aviation-related businesses that provide services to the general aviation market, including fuel and line service, aircraft sales and maintenance, avionics and engineering services and parts fabrication. Revenues from wholly-owned investees decreased to $247 million in 2012 from $249 million in 2011, primarily as a result of lower aircraft sales.
Losses and Loss Expenses. Losses and loss expenses increased to $2,948 million in 2012 from $2,658 million in 2011. The consolidated loss ratio was 63.1% in 2012 and 63.9% in 2011. Catastrophe losses, net of reinsurance recoveries and reinstatement premiums, were $80 million in 2012 compared with $153 million in 2011, a decrease of 2.0 loss ratio points. Favorable prior year reserve development was $103 million in 2012 compared with $182 million in 2011, a difference of 2.2 loss ratio points. The loss ratio excluding catastrophe losses and prior year reserve development decreased 1.0 points to 63.6% in 2012 from 64.6% in 2011. A summary of loss ratios in 2012 compared with 2011 by business segment follows:
Regional - The loss ratio of 59.6% in 2012 was 8.4 points lower than the loss ratio of 68.0% in 2011. Catastrophe losses were $24 million in 2012 compared with $85 million in 2011, a decrease of 5.7 loss ratio points. Favorable prior year reserve development was $19 million in 2012 compared with $40 million in 2011, a difference of 2.0 loss
ratio points. The loss ratio excluding catastrophe losses and prior year reserve development decreased 4.7 points to 59.1% in 2012 from 63.8% in 2011 due to favorable pricing and loss cost trends.
Expenses from Wholly-Owned Investees. Expenses from wholly-owned investees represent costs associated with aviation-related businesses that include cost of goods sold related to aircraft and other sales, labor and equipment costs related to repairs and other services and general and administrative expenses. Expenses from wholly-owned investees were $247 million in 2012 compared to $245 million in 2011.
Income Taxes. The effective income tax rate was 27% in 2012 compared to 24% in 2011. The effective income tax rate differs from the federal income tax rate of 35% primarily because of tax-exempt investment income. Tax exempt investment income comprised a lower portion of the 2012 pre-tax income and as such had a lesser impact on the effective tax rate for 2012 compared with 2011.
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, 2011 and 2010.
The Company reported net income of $391 million in 2011 compared to $446 million in 2010. The decrease in net income was primarily due to a decline in underwriting income partially offset by an increase in net investment gains. The decline in underwriting income was attributable to an increase in catastrophe losses of $72 million and a decrease in favorable prior year reserve development of $52 million. The number of weighted average diluted shares decreased as a result of the Company’s repurchases of its common stock in 2011 and 2010.
Beginning in 2005, the property casualty insurance market became more competitive and insurance rates decreased across most business lines. While prices increased in 2011, overall loss costs also generally increased and market price levels for certain lines of business remained below the prices required for the Company to achieve its return objectives. A summary of gross premiums written in 2011 compared with 2010 by line of business within each business segment follows:
Specialty premiums increased 19% to $1,818 million in 2011 from $1,526 million in 2010 primarily due to increased business in the energy and environmental markets. Gross premiums increased $121 million (27%) for other liability,$65 million (21%) for property lines, $38 million (30%) for commercial automobile, $22 million (11%) for professional liability, $10 million (11%) for products liability and $36 million (13%) for other lines.
Regional gross premiums decreased 1% to $1,149 million in 2011 from $1,160 million in 2010. Gross premiums increased $14 million (3%) for commercial multiple peril, $11 million (5%) for workers’ compensation and $7 million (4%) for other lines. Gross premiums decreased $7 million (2%) for commercial automobile. Gross premiums written decreased $36 million as a result of the transfer of fully reinsured assigned risk plan premiums to the Alternative Markets segment in 2011.
Insurance Service Fees. The Company is a servicing carrier of worker's compensation assigned risk plans for 20 states and provides insurance program management services to self-insureds, captives, governmental entities, risk retention groups, and insurance companies. Service fees were $93 million in 2011, up from $85 million in 2010, primarily as a result of an increase in fees from assigned risk plans.
Regional - The loss ratio of 68.0% in 2011 was 7.3 points higher than the loss ratio of 60.7% in 2010. Catastrophe losses were $85 million in 2011 compared with $73 million in 2010, an increase of 1.1 loss ratio points. Favorable prior year reserve development was $40 million in 2011 compared with $84 million in 2010, a difference of 4.1 loss ratio points. The loss ratio excluding catastrophe losses and favorable prior year reserve development increased 2.1 points to 63.8% in 2011 from 61.7% in 2010 due to favorable pricing and loss cost trends.
Expenses from Wholly-Owned Investees. Expenses from wholly-owned investees represent costs associated with aviation-related businesses that include cost of goods sold related to aircraft and other sales, labor and equipment costs related to repairs and other services and general and administrative expenses. Expenses from wholly-owned investees were $245 million in 2011 compared to $208 million in 2010 due to higher cost of aircraft sold as a result of higher sales volume.
Income Taxes. The effective income tax rate was 24% in 2011 as compared to 25% in 2010. The effective income tax rate differs from the federal income tax rate of 35% primarily because of tax-exempt investment income and utilization of foreign tax credits, including a reduction of the valuation allowance. Tax exempt investment income comprised a higher portion of the 2011 pre-tax income and as such had a higher impact on the effective tax rate for 2011 compared with 2010.
Pre-refunded securities are securities for which an escrow account has been established to fund the remaining payments of principal and interest through maturity. Such escrow accounts are funded almost exclusively with U.S. Treasury and U.S. government agency securities.
Equity Securities Available for Sale. Equity securities available for sale primarily represent investments in high-dividend yielding common and preferred stocks issued by large market capitalization companies.
Investment Funds. At December 31, 2012, the carrying value of investment funds was $810 million, including investments in real estate funds of $373 million and investments in energy funds of $146 million.
Loans Receivable. Loans receivable, which are carried at amortized cost, have an aggregate cost of $402 million and an aggregate fair value of $406 million at December 31, 2012. Amortized cost of these loans is net of a valuation allowance of $6 million as of December 31, 2012. The six largest loans have an aggregate amortized cost of $242 million and an aggregate fair value of $244 million as of such date and are secured by commercial real estate. These loans earn interest at floating LIBOR-based interest rates and have maturities (inclusive of extension options) through August 2025. The loans are secured by office buildings (64%) and hotels (36%) located primarily in New York City, Chicago, California, Hawaii and Boston.
Cash Flow. Cash flow provided from operating activities increased to $675 million in 2012 from $670 million in 2011. The increase in cash flow was due primarily to higher premium collections partially offset by an increase in income taxes paid. Paid losses as a percent of earned premiums were 58.0% in 2012 compared with 59.8% in 2011.
As a holding company, the Company derives cash from its subsidiaries in the form of dividends, tax payments and management fees. Maximum amounts of dividends that can be paid without regulatory approval are prescribed by statute. During 2013, the maximum amount of dividends which can be paid without regulatory approval is approximately $466 million. The ability of the holding company to service its debt obligations is limited by the ability of its insurance subsidiaries to pay dividends. In the event dividends, tax payments and management fees available to the holding company were inadequate to service its debt obligations, the Company would need to raise capital, sell assets or restructure its debt obligations.
The Company's insurance subsidiaries' principal sources of cash are premiums, investment income, service fees and proceeds from sales and maturities of portfolio investments. The principal uses of cash are payments for claims, taxes, operating expenses and dividends. The Company expects its insurance subsidiaries to fund the payment of losses with cash received from premiums, investment income and fees. The Company generally has targeted an average duration for its investment portfolio that is within one year of the average duration of its liabilities so that portions of its investment portfolio mature throughout the claim cycle and are available for the payment of claims if necessary. In the event operating cash flow and proceeds from maturities and prepayments of fixed income securities are not sufficient to fund claim payments and other cash requirements, the remainder of the Company's cash and investments is available to pay claims and other obligations as they become due. The Company's investment portfolio is highly liquid, with approximately 82% invested in cash, cash equivalents and marketable fixed income securities as of December 31, 2012. If the sale of fixed maturity securities were to become necessary, a realized gain or loss equal to the difference between the cost and sales price of securities sold would be recognized.
Debt. At December 31, 2012, the Company had senior notes, junior subordinated debentures and other debt outstanding with a carrying value of $2,115 million and a face amount of $2,135 million. The maturities of the outstanding debt are $217 million in 2013, $40 million in 2014, $201 million in 2015, $450 million in 2019, $300 million in 2020, $426 million in 2022, $1 million in 2023, $250 million in 2037 and $250 million in 2045.
Dividends. In addition to our regular dividends of $0.35 per share paid in 2012, in December 2012 we paid a special dividend of $1.00 per share. Total dividends paid in 2012 were $184 million.
Total Capital. Total capitalization (equity, senior notes and other debt and junior subordinated debentures) was $6.4 billion at December 31, 2012. The percentage of the Company’s capital attributable to senior notes, junior subordinated debentures and other debt was 33% at December 31, 2012 and 31% at December 31, 2011.
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, 2012, the Company had a deferred gross tax asset of $447 million (which primarily relates to loss and loss expense reserves and unearned premium reserves) and a gross deferred tax liability of $507 million (which primarily relates to deferred policy acquisition costs and unrealized investment gains). 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.
The Company follows customary industry practice of reinsuring a portion of its exposures in exchange for paying reinsurers a part of the premiums received on the policies it writes. Reinsurance is purchased by the Company principally to reduce its net liability on individual risks and to protect it against catastrophic losses. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance coverage. The Company monitors the financial condition of its reinsurers and attempts to place its coverages only with substantial and financially sound carriers.
(1) Rating represents S&P rating, or if not rated by S&P, A.M. Best rating.
(3) 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 20 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.
As of January 1, 2013, the Company had in place a catastrophe excess of loss reinsurance program that provides protection for net losses between $30 million and $155 million for the majority of primary business written by its U.S. companies, with additional coverage of between $5 million and $30 million depending on the region. The Company has separate catastrophe excess of loss reinsurance for business written through Lloyd's. The catastrophe reinsurance agreements are subject to certain limits, exclusions and reinstatement premiums.
Following is a summary of the Company's contractual obligations as of December 31, 2012.
The estimated payments for reserves for losses and loss expenses in the above table represent the projected (undiscounted) payments for gross loss and loss expense reserves related to losses incurred as of December 31, 2012. The estimated payments in the above table do not consider payments for losses to be incurred in future periods. These amounts include reserves for reported losses and reserves for incurred but not reported losses. Estimated amounts recoverable from reinsurers are not reflected. The estimated payments by year are based on historical loss payment patterns. The actual payments may differ from the estimated amounts due to changes in ultimate loss reserves and in the timing of the settlement of those reserves. In addition, the Company has commitments to invest up to $167 million in certain investment funds. These amounts are not included in the above table.
The Company utilizes letters of credit to back certain reinsurance payments and obligations. Outstanding letters of credit were $29 million as of December 31, 2012. The Company has made certain guarantees to state regulators that the statutory capital of certain subsidiaries will be maintained above certain minimum levels.
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. Reclassifications have been made in the 2011 and 2010 financial statements to conform to the presentation of the 2012 financial statements. 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, loss and loss adjustment expense reserves and premium estimates. Actual results could differ from those estimates.
Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value of investments is determined based on a fair value hierarchy that prioritizes the use of observable inputs over the use of unobservable inputs and requires the use of observable inputs when available. (See Note 12 of the Notes to 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 development and construction are capitalized. Buildings are depreciated on a straight-line basis over the estimated useful lives of the building. Minimum rental income is recognized on a straight-line basis over the lease term. Income and expenses from real estate are reported as net investment income. The carrying value of real estate is reviewed for impairment and an
impairment loss is recognized if the estimated undiscounted cash flows from the use and disposition of the property are less than the carrying value of the property.
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. Diluted EPS is based upon the weighted average number of common 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. Stock options for which the exercise price exceeds the average market price over the period have an anti-dilutive effect on EPS and, accordingly, are excluded from the calculation.
Contracts that do not meet the risk transfer requirements of GAAP are accounted for using the deposit accounting method. Under this method, an asset or liability is recognized at the inception of the contract based on consideration paid or received. The amount of the deposit asset or liability is adjusted at subsequent reporting dates using the interest method with a corresponding credit or charge to interest income or expense. Deposit liabilities for assumed reinsurance contracts were $75 million and $80 million at December 31, 2012 and 2011, respectively.
Goodwill and other intangibles assets are tested for impairment on an annual basis and at interim periods where circumstances require. The Company's impairment test as of December 31, 2012 indicated that there were no impairment losses related to goodwill and other intangible assets. Intangible assets of $31 million and $32 million are included in other assets as of December 31, 2012 and 2011, respectively.
In May 2011, the FASB issued guidance related to measuring and disclosing fair values. The Company's adoption of the updated guidance effective January 1, 2012 resulted in a change in the presentation of the Company's consolidated financial statements but did not have any impact on the Company's results of operations, financial position or liquidity.
All recently issued but not yet effective accounting and reporting guidance is either not applicable to the Company or is not expected to have a material impact on the Company.
The amortized cost and fair value of fixed maturity securities at December 31, 2012, 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.
At December 31, 2012 and 2011, there were no investments, other than investments in United States government and government agency securities, which exceeded 10% of common stockholders’ equity. At December 31, 2012, investments with a carrying value of $996 million were on deposit in custodial or trust accounts, of which $721 million was on deposit with state insurance departments, $184 million was on deposit in support of the Company’s underwriting activities at Lloyd’s, $62 million was on deposit as security for reinsurance clients and $29 million was on deposit as security for letters of credit issued in support of the Company’s reinsurance operations.
The Company uses put options, call options and swap contracts in order to mitigate the impact of potential changes in market conditions on the merger arbitrage trading account. These options and contracts are reported at fair value. As of December 31, 2012, the fair value of long option contracts outstanding was $1 million (notional amount of $12 million) and the fair value of short option contracts outstanding was $1 million (notional amount of $27 million). Other than with respect to the use of these trading account securities, the Company does not make use of derivatives.
(1) In 2012, the Company acquired a 49% interest in a supplier of after-market original equipment manufacturer (OEM) parts, systems and custom logistic support services for military aircraft operations worldwide for $43 million. Subsequent to December 31, 2012, the Company acquired the remaining 51% of this supplier for $43 million.
Properties in operation represent an office building in London and a long-term ground lease in Washington D.C. These properties are net of accumulated depreciation and amortization of $10,354,000 and $2,770,000, as of December 31, 2012 and 2011, respectively. Related depreciation expense was $7,583,000, $2,770,000 and $0 for the years ended December 31, 2012, 2011 and 2010, respectively. Future minimum rental income expected on operating leases relating to real estate held for investment is $1,460,000 in 2013, $1,504,000 in 2014, $1,549,000 in 2015, $1,596,000 in 2016, $1,644,000 in 2017 and $329,013,000 thereafter.
The Company's six largest loans receivable, which have an aggregate amortized cost of $242 million and an aggregate fair value of $244 million at December 31, 2012, are secured by commercial real estate located primarily in New York City, Chicago, California, Hawaii and Boston. These loans earn interest at floating LIBOR-based interest rates and have maturities (inclusive of extension options) through August 2025. As part of the evaluation process, the Company reviews certain credit quality indicators for these loans. The Company utilizes an internal risk rating system to assign a risk to each of its commercial loans. The loan rating system takes into consideration 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 Company's position in the capital structure, and the overall leverage in the capital structure. An additional credit quality indicator is the debt service coverage ratio, which compares a property's net operating income to the borrower's principal and interest payments. At December 31, 2012, each of the six largest loans referred to above had a debt service coverage ratio greater than 3.0, except one that is lower due to a recent and temporary rate abatement.
Fixed Maturity Securities - A summary of the Company’s non-investment grade fixed maturity securities that were in an unrealized loss position at December 31, 2012 is presented in the table below:
Preferred Stocks - At December 31, 2012, there were two preferred stocks in an unrealized loss position, with an aggregate fair value of $40 million and a gross unrealized loss of $2 million. One of those preferred stocks with an aggregate fair value of $15 million and a gross unrealized loss of $1 million is rated non-investment grade. Neither of these securities are delinquent or in default. Management believes the unrealized losses are due primarily to market and sector related factors and does not consider these to be OTTI.
The Company’s fixed maturity and equity securities available for sale and its trading account securities are carried at fair value. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The Company utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for similar assets in active markets. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs may only be used to measure fair value to the extent that observable inputs are not available.
The following tables present the assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011 by level:
The following tables summarize changes in Level 3 assets and liabilities for the years ended December 31, 2012 and 2011:
There were no significant transfers in or out of Level 3 during the years ended December 31, 2012 or 2011.
Claims occurring during the current year are net of loss reserve discounts of $26,078,000, $43,286,000 and $67,763,000 in 2012, 2011 and 2010, respectively.
The decrease 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 decreased by $100,667,000, $182,937,000 and $246,941,000 in 2012, 2011 and 2010, respectively.
The Company’s net reserves for losses and loss adjustment expenses relating to asbestos and environmental claims were $34 million at both December 31, 2012 and 2011. The Company’s gross reserves for losses and loss adjustment expenses relating to asbestos and environmental claims were $56 million and $59 million at December 31, 2012 and 2011, respectively. Increases in net incurred losses and loss expenses for reported asbestos and environmental claims were approximately $2 million, $1 million and $2 million in 2012, 2011 and 2010, respectively. Net paid losses and loss expenses for asbestos and environmental claims were approximately $2 million in 2012, $3 million in 2011 and $3 million in 2010. 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 excess and assumed workers’ compensation business because of the long period of time over which losses are paid. Discounting is intended to appropriately match losses and loss expenses to income earned on investment securities supporting the liabilities. The expected losses and loss expense payout pattern subject
The Company reinsures a portion of its exposures principally to reduce its net liability on individual risks and to protect against catastrophic losses. Estimated amounts due from reinsurers are reported net of reserves for uncollectible reinsurance of $1,680,000, $3,169,000 and $3,098,000 as of December 31, 2012, 2011 and 2010, respectively. The following table presents the amounts due from reinsurers as of December 31, 2012:
Senior notes and other debt consist of the following as of December 31, 2012 (the difference between the face value and the carrying value is unamortized discount):
(1) These notes were fully paid at maturity on February 15, 2013.
(2) Subsidiary debt is due as follows: $17 million in 2013, $39 million in 2014, $1 million in 2015 and $1 million thereafter.
In 2005, the Company issued $250,000,000 aggregate principal amount of 6.75% Junior Subordinated Debentures due July 26, 2045 (the “Debentures”) to W. R. Berkley Capital Trust II (the “Trust”). At December 31, 2012, the carrying value of the Debentures, net of unamortized discount, was $243,206,000. The Trust simultaneously issued an equal amount of 6.75% mandatorily redeemable preferred securities (the “Trust Preferred Securities”), which are fully and unconditionally guaranteed by the Company to the extent the Trust has funds available for payment of distributions. The Trust Preferred Securities are subject to mandatory redemption in a like amount (i) in whole but not in part upon repayment of the Debentures at maturity, (ii) in whole but not in part, at any time contemporaneously with the optional prepayment of the Debentures by the Company upon the occurrence and continuation of certain events.
Income before income taxes from domestic operations was $624 million, $469 million and $574 million for the years ended December 31, 2012, 2011 and 2010, respectively. Income before income taxes from foreign operations was $78 million, $49 million and $29 million for the years ended December 31, 2012, 2011 and 2010, respectively.
At December 31, 2012 and 2011, the tax effects of differences that give rise to significant portions of the deferred tax asset and deferred tax liability are as follows:
The Company had current tax payables of $22,546,000 and current tax receivables of $9,670,000 at December 31, 2012 and 2011, respectively. At December 31, 2012, the Company had foreign net operating loss carryforwards of $171,000, which expire beginning in 2015. The Company had provided a valuation allowance against the unutilized foreign tax credits which were fully utilized in the 2010 federal tax return. The reduction in the valuation relates primarily to the full utilization of the foreign tax credit carryforward. At December 31, 2012, the Company had no deferred tax assets for which a valuation allowance is required. The statute of limitations has closed for the Company’s tax returns through December 31, 2005. The 2006 calendar year statute of limitations remains open as a result of the carry back of capital losses from the 2009 tax year.
The Company’s insurance subsidiaries are restricted by law as to the amount of dividends they may pay without the approval of regulatory authorities. During 2013, the maximum amount of dividends which can be paid without such approval is approximately $466 million. Combined net income and policyholders’ surplus of the Company’s consolidated insurance subsidiaries, as determined in accordance with statutory accounting practices (SAP), are as follows:
The significant variances between SAP and GAAP are that for statutory purposes bonds are carried at amortized cost, acquisition costs are charged to income as incurred, deferred Federal income taxes are subject to limitations, excess and assumed workers’ compensation reserves are discounted at different discount rates and certain assets designated as “non-admitted assets” are charged against surplus. The Commissioner of Insurance of the State of Delaware has allowed the Company to discount non-tabular workers' compensation loss reserves, which is a permitted practice that differs from SAP.
The Company and its subsidiaries use office space and equipment under leases expiring at various dates. These leases are considered operating leases for financial reporting purposes. Some of these leases have options to extend the length of the leases and contain clauses for cost of living, operating expense and real estate tax adjustments. The Company also has an investment in a commercial office building that has a long-term land lease. Future minimum lease payments, without provision for sublease income, are: $38,671,000 in 2013; $33,893,000 in 2014; $29,924,000 in 2015; $25,038,000 in 2016 and $187,349,000 thereafter. Rental expense was $38,179,000, $33,003,000 and $29,936,000 for 2012, 2011 and 2010, respectively.
Pursuant to the stock incentive plan, the Company may also issue restricted stock units (RSUs) to officers of the Company and its subsidiaries. The RSUs generally vest five years from the award date and are subject to other vesting and forfeiture provisions contained in the award agreement. The following table summarizes RSU information for the three years ended December 31, 2012:
The fair value of RSUs at the date of grant are recorded as unearned compensation, a component of stockholders’ equity, and expensed over the vesting period. Following is a summary of changes in unearned compensation for the three years ended December 31, 2012:
The Company has a Long-Term Incentive Compensation Plan (“LTIP”) that provides for incentive compensation to key executives based on the growth in the Company’s book value per share over a five year period. There are 193,600 units outstanding from the 2011 grant with a maximum value of $48.4 million, of which $13 million was earned by December 31,
2012. There are 158,500 units outstanding from the 2008 grant with a maximum value of $39.6 million, of which $23 million was earned over the five years ended December 31, 2012. The 2006 grant earned $30.7 million during the five years ended December 31, 2011, and was fully paid in 2011.
Following is a summary of the amounts recognized in accumulated other comprehensive income as of December 31, 2012 and 2011:
The changes in plan assets and projected benefit obligation recognized in other comprehensive income are as follows:
The Company’s operations are presently conducted in five segments of the insurance business: Specialty, Regional, Alternative Markets, Reinsurance and International.
Our Regional companies provide insurance products and services that meet the specific needs of each regionally differentiated customer base by developing expertise in the niches that drive local communities. They provide commercial insurance products to customers primarily in 45 states and the District of Columbia. Key clients of this segment are small-to-mid-sized businesses and state and local governmental entities. The Regional business is sold through a network of non-exclusive independent agents who are compensated on a commission basis. Our Regional operating units are organized geographically in order to provide them with the flexibility to adapt quickly to local market conditions and customer needs.