The principal executive offices of Alleghany, Alleghany Capital and Roundwood are located in leased office space in New York, New York. TransRe leases office space in New York, New York for its headquarters and office space in almost all of its locations around the world. RSUI leases office space in Atlanta, Georgia for its headquarters and office space in Sherman Oaks, California. CapSpecialty leases office space in Middleton, Wisconsin for its headquarters and office space in its other locations throughout the U.S. Bourn & Koch owns its principal offices and manufacturing facilities, which are located in Rockford, Illinois and leases certain offices and manufacturing facilities, which are located in Olympia, Washington. Kentucky Trailer leases its principal offices and manufacturing facilities, which are located in Louisville, Kentucky, and has additional leased manufacturing facilities in locations including Michigan, Illinois, Iowa and the Netherlands. IPS leases office space in Blue Bell, Pennsylvania for its headquarters and office space in its locations around the world. Jazwares owns and leases office space in Sunrise, Florida for its headquarters and office space in its locations around the world. W&W|AFCO Steel owns its principal office in Oklahoma City, Oklahoma for its headquarters and owns its principal facilities, which are located in Arkansas, Colorado, Oklahoma, North Carolina and Texas. Concord leases office space in Raleigh, North Carolina for its headquarters. SORC leases office space in Golden, Colorado for its headquarters and owns facilities, mineral rights and land in other locations in the Midwestern and Southeastern U.S. Alleghany Properties leases office space in Sacramento, California. Management considers its facilities suitable and adequate for the current level of operations. See Note 12(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our leases.
(1) On October 1, 2018, we acquired Concord; on February 7, 2018, we acquired Hirschfeld; on April 28, 2017, we acquired W&W|AFCO Steel; on April 15, 2016, we acquired Jazwares; and on October 31, 2015, we acquired IPS. On December 31, 2017, we sold PacificComp.
The following is a discussion and analysis of our financial condition and results of operations for the twelve months ended December 31, 2018, 2017 and 2016. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties and that are not historical facts, including statements about our beliefs and expectations. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and particularly under the headings “Risk Factors,” “Business” and “Note on Forward-Looking Statements” contained in Item 1A, Item 1, and Part I of this Form 10-K, respectively.
Throughout this Form 10-K, our analysis of our financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with GAAP. Our results of operations have been presented in the way that we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use financial information in evaluating our performance. This presentation includes the use of underwriting profit and operating earnings before income taxes, which are “non-GAAP financial measures,” as such term is defined in Item 10(e) of Regulation S-K promulgated by the SEC. The presentation of these financial measures is not intended to be considered in isolation or as a substitute for, or superior to, financial information prepared and presented in accordance with GAAP. These measures may also be different from non-GAAP financial measures used by other companies, limiting their usefulness for comparison purposes. A discussion of our calculation and use of these financial measures is provided below.
Underwriting profit is a non-GAAP financial measure for our reinsurance and insurance segments. Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP and does not include: (i) net investment income; (ii) change in the fair value of equity securities; (iii) net realized capital gains; (iv) other than temporary impairment, or “OTTI” losses; (v) noninsurance revenue; (vi) other operating expenses; (vii) corporate administration; (viii) amortization of intangible assets; and (ix) interest expense. We use underwriting profit as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of our reinsurance and insurance segments and believe that underwriting profit provides useful additional information to investors because it highlights net earnings attributable to our reinsurance and insurance segments’ underwriting performance. Earnings before income taxes may show a profit despite an underlying underwriting loss, and when underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. A reconciliation of underwriting profit to earnings before income taxes is presented within “Consolidated Results of Operations.”
Operating earnings before income taxes is a non-GAAP financial measure for our Alleghany Capital segment. Operating earnings before income taxes represents noninsurance revenue and net investment income less other operating expenses and interest expense, and does not include: (i) amortization of intangible assets; (ii) change in the fair value of equity securities; (iii) net realized capital gains; (iv) OTTI losses; and (v) income taxes. Because operating earnings before income taxes excludes amortization of intangible assets, change in the fair value of equity securities, net realized capital gains, OTTI losses and income taxes, it provides an indication of economic performance that is not affected by levels of effective tax rates or levels of amortization resulting from acquisition accounting. We use operating earnings before income taxes as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of certain of our noninsurance operating subsidiaries and investments. A reconciliation of operating earnings before income taxes to earnings before income taxes is presented within “Consolidated Results of Operations.”
In prior filings, we have used Adjusted EBITDA as a non-GAAP financial measure for our noninsurance operating subsidiaries held by Alleghany Capital. We believe that operating earnings before income taxes is a more useful non-GAAP financial measure, as it reflects ongoing capital expenditures through the inclusion of depreciation expense (a component of other operating expenses) and ongoing levels of debt through the inclusion of interest expense.
Net favorable prior accident year loss reserve development was $329.0 million in 2018, compared with $298.6 million in 2017 and $368.0 million in 2016.
Noninsurance revenue for Alleghany Capital was $1,574.6 million in 2018, compared with $896.9 million in 2017 and $677.8 million in 2016.
We incurred significant catastrophe losses in 2018, primarily arising from: wildfires in California, which caused widespread property damage primarily in the fourth quarter of 2018; Typhoons Jebi and Trami, each of which caused widespread property damage and flooding in September 2018, primarily in Japan; Hurricane Michael, which caused widespread property damage and flooding in October 2018, primarily in Florida and Georgia; and Hurricane Florence, which caused widespread property damage and flooding in September 2018, primarily in North Carolina. We also incurred significant catastrophe losses in 2017, primarily arising from three major hurricanes. Hurricane Irma caused widespread property damage and flooding in September 2017, primarily in Florida. Hurricane Harvey caused widespread property damage and flooding in August 2017, primarily in Texas. Hurricane Maria caused widespread property damage and flooding in September 2017, primarily in Puerto Rico. Our loss estimates for all of these catastrophes were based on information available at the time, including an analysis of reported claims, an underwriting review of in-force contracts, estimates of losses resulting from wind and other perils, including storm surge and flooding to the extent covered by applicable policies, and other factors requiring considerable judgment.
The following table presents the impact of our catastrophe losses, net of reinsurance, for 2018 and 2017:
(1) Includes $17.4 million attributable to RSUI and $0.9 million attributable to CapSpecialty.
(4) Includes $97.6 million attributable to RSUI and $0.2 million attributable to CapSpecialty.
(5) Includes $86.6 million attributable to RSUI and $0.2 million attributable to CapSpecialty.
The following table presents our consolidated revenues, costs and expenses and earnings.
2018 vs 2017. The increase in gross premiums written in 2018 from 2017 is primarily attributable to an increase at our reinsurance segment and, to a lesser extent, growth at CapSpecialty and RSUI, partially offset by the impact of the sale of PacificComp. The increase at our reinsurance segment primarily reflects increases in premiums written by the North America and Asia-Pacific operations and the impact of TransRe’s August 29, 2018 purchase of renewal rights associated with a certain block of U.S. treaty reinsurance business focused on regional property and casualty, accident and health and personal auto lines of business, or the “Renewal Rights Purchase.” The increase in gross premiums written at our reinsurance segment was partially offset by a decrease in gross premiums written related to a certain large whole account quota share treaty, or the “Quota Share Treaty,” due to a reduction of TransRe’s quota share participation. Premiums written related to the Quota Share Treaty were $737.6 million and $780.9 million in 2018 and 2017, respectively.
The decrease in net premiums earned in 2017 from 2016 primarily reflected a decrease at our reinsurance segment due primarily to a decrease in net premiums written in earlier quarters, partially offset by an increase at our insurance segment, reflecting growth of premiums written at CapSpecialty and PacificComp.
Net loss and LAE. The following table presents our consolidated net loss and LAE:
2017 vs 2016. The increase in net loss and LAE in 2017 from 2016 primarily reflected a significant increase in catastrophe losses at our reinsurance and insurance segments.
A detailed comparison of net loss and LAE by segment for 2018, 2017 and 2016 is contained on pages 84 through 86 and pages 91 through 93.
2018 vs 2017. The decrease in underwriting loss in 2018 from 2017 primarily reflects significantly lower catastrophe losses at our reinsurance and insurance segments, as discussed above.
In the first quarter of 2018, we adopted new investment accounting guidance which required changes in the fair value of equity securities, except those accounted for under the equity method, to be recognized in net earnings. In earlier periods, equity securities were considered to be available-for-sale, or “AFS,” and were included in the analysis of OTTI. See Note 1(r) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information regarding our adoption of this new guidance.
The change in the fair value of equity securities in 2018 reflects depreciation in the value of our equity securities portfolio, primarily from our holdings in the energy, consumer, communications and materials sectors, partially offset by appreciation in the value of our equity holdings in the information technology sector.
The increase in net realized capital gains in 2017 from 2016 primarily reflected a $98.8 million capital loss due to an impairment charge from the write-down of certain SORC assets as of December 31, 2016, as more fully described in the following pages, partially offset by lower net realized capital gains from the sale of equity securities.
The decrease in OTTI losses in 2017 from 2016 reflects lower losses related to debt securities.
The increase in noninsurance revenue and other operating expenses in 2018 from 2017 primarily reflects the acquisitions of Hirschfeld, W&W|AFCO Steel and, to a lesser extent, Concord. The increase in other operating expenses in 2018 from 2017 was partially offset by a decrease in long-term incentive compensation at our reinsurance and insurance segments, as discussed above.
Interest expense. The increase in interest expense in 2018 from 2017 primarily reflects borrowings at W&W|AFCO Steel and, to a lesser extent, Concord, as well as the impact of higher interest rates. The increase in interest expense in 2017 from 2016 reflected
new or increased borrowings at Jazwares, IPS and Bourn & Koch and borrowings at W&W|AFCO Steel. See Note 8 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information.
The Tax Act was signed into law on December 22, 2017. Among other provisions, the Tax Act reduced the corporate federal income tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018, for the 2018 tax year. As a result, the value of our deferred tax assets and liabilities as of December 31, 2017 was reduced. The net impact of this reduction to our consolidated 2017 tax expense was not material.
2017 vs 2016. The income tax benefit in 2017, compared with income tax expense in 2016, reflected the impact of taxable losses arising from Hurricanes Irma, Harvey and Maria. In addition, income taxes in 2016 included prior period income tax expense adjustments. The effective tax rate in 2017 compared with 2016 primarily reflected income tax benefits from taxable losses arising from Hurricanes Irma, Harvey and Maria in 2017 and, to a lesser extent, a tax benefit associated with the sale of PacificComp, as well as prior period income tax expense adjustments in 2016, which included $16.1 million of out-of-period reductions to current and deferred TransRe tax assets recorded in 2016 that related primarily to periods prior to our merger with TransRe in 2012.
2018 vs 2017. The increase in earnings before income taxes in 2018 from 2017 primarily reflects significantly lower catastrophe losses and, to a lesser extent, lower long-term incentive compensation expense accruals at the Alleghany parent company and our reinsurance and insurance segments, partially offset by depreciation of our equity securities portfolio, which was recorded in earnings as a result of our adoption of new investment accounting guidance in 2018, and net realized capital losses in 2018 compared with net realized capital gains in 2017, all as discussed above. The decrease in net earnings attributable to Alleghany stockholders in 2018 from 2017 primarily reflects a significantly lower income tax benefit, as discussed above.
2017 vs 2016. The decrease in earnings before income taxes and net earnings attributable to Alleghany stockholders in 2017 from 2016 primarily reflected significant catastrophe losses related to Hurricanes Irma, Harvey and Maria at our reinsurance and insurance segments, as discussed above.
(2) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, change in the fair value of equity securities, net realized capital gains, OTTI losses, noninsurance revenue, other operating expenses, corporate administration, amortization of intangible assets and interest expense. Underwriting profit is a non-GAAP financial measure and does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. See “Comment on Non-GAAP Financial Measures” herein for additional detail on the presentation of our results of operations.
ceding companies, premiums written are estimated based on historical patterns and other relevant factors. Any differences between these estimates and actual data subsequently reported are recorded in the period when actual data becomes available. Excluding the impact of changes in foreign currency exchange rates, gross premiums written decreased by 5.6 percent in 2017 from 2016. The decrease in net premiums earned in 2017 from 2016 primarily reflected the decline in net premiums written in recent quarters and the impact of changes in foreign currency exchange rates, partially offset by $4.3 million of net reinstatement premiums earned on treaties impacted by catastrophe losses. Excluding the impact of changes in foreign currency exchange rates, net premiums earned decreased by 1.5 percent in 2017 from 2016.
Property. The decrease in net loss and LAE in 2018 from 2017 primarily reflects lower catastrophe losses, partially offset by higher non-catastrophe losses and less favorable prior accident year loss reserve development. The catastrophe losses in 2018 include
$163.2 million related to Typhoon Jebi, $160.6 million related to wildfires in California, $76.7 million related to Hurricane Michael, $31.9 million related to Hurricane Florence, $29.7 million related to Typhoon Trami and $19.7 million related to several severe weather events in East Asia. Catastrophe losses in 2017 included $181.3 million related to Hurricane Maria in September 2017, $128.1 million related to Hurricane Irma in September 2017, $110.8 million related to Hurricane Harvey in August 2017, $69.2 million related to wildfires in California in the fourth quarter of 2017 and $26.9 million related to earthquakes in Mexico in September 2017.
(2) Reflects favorable prior accident year loss reserve development related to several catastrophes primarily in the 2016 accident year.
(4) Primarily reflects favorable prior accident year loss reserve development in the 2015 and 2016 accident years, partially offset by unfavorable prior accident year loss reserve development in the 2017 accident year.
The favorable prior accident year loss reserve development in 2018, 2017 and 2016 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The favorable prior accident year loss reserve development in 2018 did not impact assumptions used in estimating TransRe’s loss and LAE liabilities for business earned in 2018.
Casualty & other. The increase in net loss and LAE in 2018 from 2017 primarily reflects the impact of higher net premiums earned, partially offset by lower catastrophe losses. Catastrophe losses in 2018 relate primarily to the marine and nontraditional lines of business and include $4.6 million related to Hurricane Florence in September 2018, $3.4 million related to Hurricane Michael in October 2018, $3.1 million related to wildfires in California in the fourth quarter of 2018, $4.0 million related to Typhoon Jebi in September 2018 and $3.2 million related to several severe weather events in East Asia. Catastrophe losses in 2017 relate primarily to the marine lines of business and include $26.2 million related to Hurricane Irma in September 2017, $20.1 million related to Hurricane Harvey in August 2017, $15.4 million related to Hurricane Maria in September 2017, $1.6 million related to wildfires in California in the fourth quarter of 2017 and $1.5 million related to earthquakes in Mexico in September 2017.
(2) Represents unfavorable prior accident year loss reserve development related to the U.K. Ministry of Justice’s reduction in the discount rate used to calculate lump-sum bodily injury payouts in personal injury insurance claims in the U.K to negative 0.75 percent as of March 20, 2017 from 2.50 percent.
(5) Generally reflects favorable prior accident year loss reserve development reserves in a variety of casualty & other lines of business primarily in the 2003 through 2015 accident years.
Casualty & other. The slight decrease in commissions, brokerage and other underwriting expenses in 2018 from 2017 primarily reflects lower commission rates and lower short-term incentive compensation accruals, partially offset by the impact of higher net premiums earned. The decrease in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflected lower short-term incentive compensation expense accruals arising from the significant catastrophe losses in 2017, the impact of lower net premiums earned and a decrease in profit commissions related to the Malpractice Treaties.
Casualty & other. The increase in underwriting profit in 2018 from 2017 primarily reflects lower catastrophe losses, as discussed above. The decrease in underwriting profit in 2017 from 2016 primarily reflected significant catastrophe losses related to Hurricanes Irma, Harvey and Maria, as well as less favorable prior accident year loss reserve development, as discussed above.
(1) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, change in the fair value of equity securities, net realized capital gains, OTTI losses, noninsurance revenue, other operating expenses, corporate administration, amortization of intangible assets and interest expense. Underwriting profit is a non-GAAP financial measure and does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. See “Comment on Non-GAAP Financial Measures” herein for additional detail on the presentation of our results of operations.
Insurance Segment: Premiums. The following table presents premiums for the insurance segment:
The increase in net premiums earned in 2018 from 2017 primarily reflects an increase in gross premiums written in recent quarters, partially offset by higher ceded premiums earned related to reinstatement premiums on RSUI’s per risk property reinsurance treaties and the impact of growth in the heavily-reinsured property lines of business. The decrease in net premiums earned in 2017 from 2016 primarily reflected a general trend of declining gross premiums written prior to the fourth quarter of 2017.
CapSpecialty. The increases in gross premiums written in 2018 from 2017 and in 2017 from 2016 primarily reflect growth in the professional liability and miscellaneous medical lines of business due to CapSpecialty’s distribution initiatives and expanded product offerings. The increase in gross premiums written in 2018 from 2017 also reflects the impact of CapSpecialty’s February 20, 2018 purchase of certain renewal rights associated with a small environmental block of business and growth in the surety lines of business.
RSUI. The decrease in net loss and LAE in 2018 from 2017 primarily reflects significantly lower catastrophe losses and, to a lesser extent, higher favorable prior accident year loss reserve development, partially offset by the impact of an increase in net premiums earned. The increase in net loss and LAE in 2017 from 2016 primarily reflected higher catastrophe losses.
The catastrophe losses in 2018 include $55.1 million related to Hurricane Michael, $33.8 million from Hurricane Florence and $17.4 million related to wildfires in California, as well as losses related to flooding and severe weather in the Northeastern U.S. and California and typhoons in Japan. Catastrophe losses in 2017 included $97.6 million related to Hurricane Irma, $86.6 million related to Hurricane Harvey and $20.1 million related to Hurricane Maria. Catastrophe losses in 2017 also reflected losses related to flooding in California and severe weather primarily in the Southeastern and Midwestern U.S. Catastrophe losses in 2016 primarily reflected losses related to flooding and severe weather primarily in Texas in April and May, losses related to wildfires in Alberta, Canada in May, losses related to flooding and severe weather primarily in Louisiana and the Midwestern U.S. in the third quarter, losses related to wildfires in Tennessee in November and $26.8 million of losses related to Hurricane Matthew.
(3) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business in the 2006 through 2012 accident years.
(4) Primarily reflects favorable prior accident year loss reserve development related to Hurricane Irma in the 2017 accident year and, to a lesser extent, Hurricane Matthew in the 2016 accident year, as well as various other losses not classified as catastrophes in recent accident years.
(5) Primarily reflects favorable catastrophe prior accident year loss reserve development in the 2016 accident year, partially offset by unfavorable prior accident year property loss reserve development in the binding authority lines of business primarily in the 2015 and 2016 accident years.
(6) Includes favorable prior accident year loss reserve development of ($20.6) million related to Super Storm Sandy in 2012 and various other smaller amounts primarily in the non-catastrophe property lines of business in recent accident years.
CapSpecialty. The increase in net loss and LAE in 2018 from 2017 primarily reflects the impact of higher net premiums earned and higher 2018 accident year losses due primarily to an increase in net premiums earned for certain lines of business with a higher loss ratio, partially offset by lower catastrophe losses and an increase in favorable prior accident year loss reserve development. The increase in net loss and LAE in 2017 from 2016 primarily reflected the impact of higher net premiums earned, higher 2017 accident year losses and less favorable prior accident year loss reserve development in 2017.
The favorable prior accident year loss reserve development in 2018, 2017 and 2016 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods. The favorable prior accident year loss reserve development in 2018 did not impact assumptions used in estimating CapSpecialty’s loss and LAE liabilities for business earned in 2018.
PacificComp. The increase in commissions, brokerage and other underwriting expenses in 2017 from 2016 primarily reflected the impact of higher net premiums earned and relatively stable overhead expenses.
RSUI. The underwriting profit in 2018, compared with the underwriting loss in 2017, primarily reflects significantly lower catastrophe losses and, to a lesser extent, an increase in favorable prior accident year loss reserve development, all as discussed above. The underwriting loss in 2017, compared with the underwriting profit in 2016, primarily reflected the impact of significant catastrophe losses related to Hurricanes Irma, Harvey and Maria, as discussed above.
Net Investment Income. The increase in net investment income in 2018 from 2017 primarily reflects higher dividend income primarily resulting from an increase in the size of our equity securities portfolio during the first three quarters of 2018 and, to a lesser extent, an increase in interest income primarily resulting from higher yields on short-term investments and floating-rate debt securities, partially offset by the impact of the sale of PacificComp.
The increase in net investment income in 2018 from 2017 also reflects higher income from AIHL’s limited partnership interests in certain subsidiaries of Ares, partially offset by lower income from other partnerships. Partnership income in 2018 includes a
$12.9 million increase in the carrying value of our equity investment in Ares. See Note 4(i) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information.
Net Realized Capital Gains. The decrease in net realized capital gains in 2018 from 2017 primarily reflects the absence of net realized capital gains from equity securities in 2018 as a result of our adoption of the new investment accounting guidance discussed above, net realized capital losses taken in 2018 from the sale of debt securities, partially offset by a $45.7 million gain on AIHL’s conversion of its limited partnership interests in certain subsidiaries of Ares into Ares common units. See Note 4(i) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on AIHL’s conversion.
Other Than Temporary Impairment Losses. OTTI losses in 2018 reflect $1.3 million of unrealized losses on debt securities, primarily in the energy and industrial sectors, that were deemed to be other than temporary and, as such, were required to be charged against earnings. The determination that unrealized losses on debt securities were other than temporary was primarily due to the deterioration of creditworthiness of the issuer.
Upon the ultimate disposition of the securities for which OTTI losses have been recorded, a portion of the loss may be recoverable depending on market conditions at the time of disposition. After adjusting the cost basis of securities for the recognition of OTTI losses, the remaining gross unrealized investment losses for debt securities as of December 31, 2018 were deemed to be temporary, based on, among other factors: (i) the duration of time and the relative magnitude to which the fair values of these securities had been below cost were not indicative of an OTTI loss; (ii) the absence of compelling evidence that would cause us to call into question the financial condition or near-term business prospects of the issuers of the securities; and (iii) our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery.
See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on gross unrealized investment losses for debt securities as of December 31, 2018.
(1) For industrial and non-industrial operations: (i) noninsurance revenue consists of the sale of manufactured goods and services; and (ii) other operating expenses consist of the cost of goods and services sold and selling, general and administrative expenses. Other operating expenses also include finders’ fees, legal and accounting costs and other transaction-related expenses of $7.7 million, $7.2 million and $7.4 million for 2018, 2017 and 2016, respectively.
(1) Federal income taxes for most Alleghany Capital subsidiaries are incurred at the Alleghany Capital corporate level. Estimated federal income tax (expense) benefit incurred at the Alleghany Capital corporate level attributable to industrial and non-industrial operations for 2018 were ($5.3) million and ($9.4) million, respectively, for 2017 were ($2.4) million and ($10.7) million, respectively, and for 2016 were ($3.7) million and ($3.4) million, respectively.
(3) Primarily reflects funding provided by Alleghany Capital for the acquisition of W&W|AFCO Steel and the investment in Wilbert.
(4) During 2018, the noncontrolling interests outstanding were approximately as follows: Bourn & Koch - 11 percent; Kentucky Trailer - 21 percent; W&W|AFCO Steel - 20 percent; IPS - 15 percent; Jazwares - 23 percent; and Concord - 15 percent.
(5) Primarily reflects funding provided by Alleghany Capital to W&W|AFCO Steel for the acquisition of Hirschfeld and funding provided by Alleghany to Alleghany Capital for the acquisition of Concord.
Other operating expenses. The increase in other operating expenses in 2018 from 2017 primarily reflects a significant increase in industrial operations, due primarily to the acquisitions of Hirschfeld and W&W|AFCO Steel and, to a lesser extent, higher costs related to higher sales at Kentucky Trailer and Bourn & Koch, as well as facility consolidation activities at Kentucky Trailer. With respect to non-industrial operations, the increase in other operating expenses in 2018 primarily reflects higher costs at Jazwares and IPS resulting from higher sales, as well as the acquisition of Concord. Higher costs at Jazwares also reflect increased marketing expenditures and the impact of certain Toys “R” Us Inc. liquidation-related charges.
Amortization of intangible assets. The increase in amortization expense in 2018 from 2017 primarily reflects the W&W|AFCO Steel, Hirschfeld and Concord acquisitions. The decrease in amortization expenses in 2017 from 2016 primarily reflected a decrease in amortization expense at IPS, as certain of IPS’s intangible assets were fully amortized as of December 31, 2016, partially offset by amortization of net intangible assets related to the acquisition of W&W|AFCO Steel.
Interest expense. The increase in interest expense in 2018 from 2017 primarily reflects borrowings at W&W|AFCO Steel and, to a lesser extent, Concord. The increase in interest expense in 2017 from 2016 reflected new or increased borrowings at Jazwares, IPS and Bourn & Koch and borrowings at W&W|AFCO Steel, as well as the impact of higher interest rates.
Earnings (losses) before income taxes. The increase in earnings before income taxes in 2018 from 2017 primarily reflects increased earnings in the non-industrial operations and the industrial operations, partially offset by the Jazwares Settlement Gain. The increase in non-industrial earnings before income taxes in 2018 primarily reflects the impact of increased sales at Jazwares, partially offset by increased marketing expenditures and the impact of certain Toys “R” Us Inc. liquidation-related charges, as discussed above. To a lesser extent, the increase in non-industrial earnings before income taxes in 2018 also reflects the impact of increased sales at IPS and the acquisition of Concord, all as discussed above. The increase in the industrial earnings before income taxes primarily reflects Alleghany Capital’s earnings from its investment in Wilbert, as well as the impact of increased sales at Kentucky Trailer and Bourn & Koch, all as discussed above. The increase in earnings before income taxes from the acquisitions of W&W|AFCO Steel and Hirschfeld were largely offset by an increase in amortization expense.
The increase in earnings before income taxes in 2017 from 2016 primarily reflected the Jazwares Settlement Gain, partially offset by the Jazwares Remeasurement Gain, all as discussed above. Earnings before income taxes in 2017 also reflected higher margins of the industrial and non-industrial operations, the inclusion of W&W|AFCO Steel and our investment in Wilbert.
The SORC assets that were written-down in 2016 related specifically to SORC’s acquisition of a certain legacy oil field for the sole purpose of applying enhanced oil recovery techniques. After completing construction of its underground facility in 2014, SORC commenced its drilling program in 2015. The drilling program, however, was delayed by third-party equipment problems that were subsequently corrected, as well as a longer than expected trial-and-error process determining the optimum well completion technique for the reservoir and efforts to address a lack of vertical permeability in the reservoir formation. SORC engaged a third-party petroleum engineering firm to provide an assessment of its oil-recovery prospects and based on this assessment and other factors including oil prices, SORC wrote-down its legacy oil field assets to estimated fair value as of December 31, 2016. On December 29, 2017, SORC sold this legacy oil field and recorded a realized capital loss of $4.8 million.
Noninsurance revenue. The increase in noninsurance revenue in 2018 from 2017 primarily reflects increases in property sales at Alleghany Properties and, to a lesser extent, increases in oil sales at SORC. Noninsurance revenue includes the sale in September 2018 of 68 acres of land located in Sacramento, California for approximately $20 million. The decrease in other revenue in 2017 from 2016 primarily reflected lower real estate sales activity at Alleghany Properties.
Losses before income taxes. The increase in losses before income taxes in 2018 from 2017 primarily reflects depreciation in the value of equity securities held at the Alleghany parent company-level and the SORC impairment loss, partially offset by an increase in sales at Alleghany Properties and lower corporate administration expense, all as discussed above. The decrease in losses before income taxes in 2017 from 2016 primarily reflected a decrease in realized capital losses in 2017 and higher net investment income, partially offset by an increase in corporate administration, all as discussed above.
Our reinsurance and insurance subsidiaries analyze, at least quarterly, liabilities for unpaid loss and LAE established in prior years and adjust their expected ultimate cost, where necessary, to reflect favorable or unfavorable development in loss experience and new information, including, for certain catastrophe events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid loss and LAE, both favorable and unfavorable, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior accident year loss reserve development. The following table presents the reserves established in connection with the loss and LAE of our reinsurance and insurance segments on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate loss (including for IBNR) and LAE.
(1) Primarily consists of the following reinsurance lines of business: directors’ and officers’ liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; mortgage reinsurance; surety; asbestos-related illness and environmental impairment liability; and credit.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2017 and December 31, 2016. Gross and net loss and LAE reserves, and reinsurance recoverables as of December 31, 2017 increased from December 31, 2016, primarily reflecting significant catastrophe losses, partially offset by the sale of PacificComp. Catastrophe losses in 2017, net of reinsurance, included
$252.1 million related to Hurricane Irma, $217.7 million related to Hurricane Harvey and $216.8 million related to Hurricane Maria, all as discussed above.
Our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines of business, improve risk-adjusted portfolio returns and enable them to increase gross premiums writings and risk capacity without requiring additional capital. Our reinsurance and insurance subsidiaries purchase reinsurance and retrocessional coverages from highly-rated third-party reinsurers. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such reinsurance portion not paid by these reinsurers. As such, funds, trust agreements and letters of credit are held to collateralize a portion of our reinsurance and insurance subsidiaries’ reinsurance recoverables, and our reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite or assume with multiple reinsurance programs.
As of December 31, 2018, our reinsurance and insurance subsidiaries had total reinsurance recoverables of $1,921.3 million, consisting of $1,857.4 million of ceded outstanding loss and LAE and $63.9 million of recoverables on paid losses. See Part I, Item 1, “Business - Reinsurance Protection” of this Form 10-K for additional information on the reinsurance purchased by our reinsurance and insurance subsidiaries.
(3) Represents reinsurance recoverables secured by funds held, trust agreements or letters of credit.
We believe our most critical accounting estimates are those with respect to the liability for unpaid loss and LAE reserves, fair value measurements of certain financial assets, OTTI losses on investments, goodwill and other intangible assets and reinsurance
premium revenues, as they require management’s most significant exercise of judgment on both a quantitative and qualitative basis. The accounting estimates that result require the use of assumptions about certain matters that are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, our financial condition, results of operations and cash flows would be affected, possibly materially.
While the reserving process is difficult for insurance business, the inherent uncertainties of estimating loss reserves are even greater for reinsurance business, due primarily to the longer-tailed nature of most of the reinsurance business, the diversity of development patterns among different types of reinsurance contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which can be subject to change without notice. TransRe writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business for classes such as medical malpractice, directors’ and officers’ liability, errors and omissions liability and general liability. Claims from such classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict.
The estimation of unpaid loss and LAE for our reinsurance operations is principally based on reports and individual case estimates received from ceding companies. Data received from cedants is audited periodically by TransRe’s claims and underwriting
In addition, the estimation of unpaid loss and LAE, including IBNR, for our reinsurance operations also takes into account assumptions with respect to many factors that will affect ultimate loss costs but are not yet known. The process by which actual carried reserves are determined considers not only actuarial estimates but a myriad of other factors. Such factors, both internal and external, which contribute to the variability and unpredictability of loss costs, include trends related to jury awards, social trends, medical inflation, worldwide economic conditions, tort reforms, judicial interpretations of coverages, the regulatory environment, underlying policy pricing, terms and conditions and claims handling, among others. In addition, information gathered through underwriting and claims audits is also considered. We assess the reasonableness of our unpaid loss and LAE for our reinsurance operations using various actuarial methodologies, principally the paid development method, the reported loss development method and the Bornhuetter-Ferguson method as described below.
Reported and paid loss emergence patterns represent management’s expectation of how losses will be reported and ultimately paid in the future based on the historical emergence patterns of reported and paid losses and are derived from
Asbestos-Related Illness and Environmental Impairment Reserves. Loss and LAE include amounts for risks related to asbestos-related illness and environmental impairment. The reserves carried for such claims, including the IBNR portion, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illness and environmental impairment losses. This uncertainty is due to, among other reasons, inconsistent and changing court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible future changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings. Although we are unable at this time to determine whether additional reserves, which could have a material adverse effect upon our results of operations, may be necessary in the future, we believe that our asbestos-related illness and environmental impairment reserves are adequate as of December 31, 2018. See Note 12(c) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” and pages 44 and 45 of this Form 10-K for additional information on loss and LAE reserves related to asbestos-related illness and environmental impairment.
business, improve risk-adjusted portfolio returns and enable them to increase gross premium writings and risk capacity without requiring additional capital. Our reinsurance and insurance subsidiaries purchase reinsurance and retrocessional coverages from highly-rated third-party reinsurers. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance subsidiaries would remain liable for such reinsurance portion not paid by these reinsurers. Recoverables recorded with respect to claims ceded to reinsurers under reinsurance contracts are predicated in large part on the estimates for unpaid losses and, therefore, are also subject to a significant degree of uncertainty. In addition to the factors cited above, reinsurance recoverables may prove uncollectible if a reinsurer is unable or unwilling to perform under a contract. Reinsurance purchased by our reinsurance and insurance subsidiaries does not relieve them of their obligations to their own policyholders or cedants. Additional information regarding the use of, and risks related to the use of reinsurance by our reinsurance and insurance subsidiaries can be found on pages 46, 47, 56 and 57 of this Form 10-K. Also see Note 1(f) and Note 5 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our reinsurance recoverables.
Goodwill and other intangible assets, net of amortization, are recorded as a consequence of business acquisitions. Goodwill represents the excess, if any, of the amount paid to acquire subsidiaries and other businesses over the fair value of their net assets as of the date of acquisition. Other intangible assets are recorded at their fair value as of the acquisition date. A significant amount of judgment is needed to determine the fair value as of the date of acquisition of other intangible assets and the net assets acquired in a business acquisition. The determination of the fair value of other intangible assets and net assets often involves the use of valuation
models and other estimates, which involve many assumptions and variables and are inherently subjective. The fair value estimates may include the use of financial projections and discount rates. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and intangible assets that have an indefinite useful life are not subject to amortization.
Our consolidated balance sheet as of December 31, 2018 includes goodwill of $455.1 million related primarily to Concord, W&W|AFCO Steel, Jazwares, IPS, RSUI, CapSpecialty, Bourn & Koch and Kentucky Trailer, and intangible assets, net of amortization, of $553.1 million related primarily to TransRe, Concord, W&W|AFCO Steel, Jazwares, IPS, RSUI, CapSpecialty, Bourn & Koch and Kentucky Trailer. See Note 1(i) and Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional information on our goodwill and other intangible assets.
Sale of Subsidiary. On December 31, 2017, AIHL sold PacificComp to CopperPoint for total cash consideration of approximately $158 million, at which time: (i) approximately $442 million of PacificComp assets, consisting primarily of debt securities, and approximately $316 million of PacificComp liabilities, consisting primarily of loss and LAE reserves, were transferred; and (ii) AIHL recorded an after-tax gain of approximately $16 million, which included a tax benefit. In connection with the transaction, AIHL Re provides adverse development reinsurance coverage on PacificComp’s pre-acquisition claims, subject to certain terms and conditions. AIHL Re’s obligations, which are guaranteed by Alleghany, are subject to an aggregate limit of $150.0 million and a final commutation and settlement as of December 31, 2024.
factors. The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. There were no borrowings under the Credit Agreement from inception through December 31, 2018.
The Credit Agreement replaced our previous four-year credit agreement, or the “Prior Credit Agreement,” which provided for an unsecured revolving credit facility in an aggregate principal amount of up to $200.0 million. The Prior Credit Agreement was terminated on July 31, 2017 in advance of its scheduled October 15, 2017 expiration date. There were no borrowings under the Prior Credit Agreement in the seven months ended July 31, 2017.
Common Stock Repurchases. In July 2014, our Board of Directors authorized the repurchase of shares of our common stock at such times and at prices as management determines to be advisable, up to an aggregate of $350.0 million, or the “2014 Repurchase Program.” In November 2015, our Board of Directors authorized the repurchase, upon the completion of the 2014 Repurchase Program, of additional shares of our common stock at such times and at prices as management determines to be advisable, up to an aggregate of $400.0 million, or the “2015 Repurchase Program.” In June 2018, our Board of Directors authorized, upon the completion of the 2015 Repurchase Program, the repurchase of additional shares of our common stock at such times and at prices as management determines to be advisable, up to an aggregate of $400.0 million, or the “2018 Repurchase Program.” In the first quarter of 2016, we completed the 2014 Repurchase Program and subsequent repurchases have been made pursuant to the 2015 Repurchase Program. In the fourth quarter of 2018, we completed the 2015 Repurchase Program and subsequent repurchases have been made pursuant to the 2018 Repurchase Program. As of December 31, 2018, we had $271.5 million remaining under our share repurchase authorization.
The following table presents the shares of our common stock that we repurchased in 2018, 2017 and 2016 pursuant to the 2014 Repurchase Program, the 2015 Repurchase Program and the 2018 Repurchase Program, as applicable:
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. The following table presents certain long-term aggregate contractual obligations and credit-related financial commitments as of December 31, 2018:
Investments in Certain Other Invested Assets. In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited, or “Pillar Holdings,” a Bermuda-based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities. Additionally, TransRe invested $175.0 million and AIHL invested $25.0 million in limited partnership funds managed by Pillar Holdings, or the “Funds.” The objective of the Funds is to create portfolios with attractive risk-reward characteristics and low correlation with other asset classes, using the extensive reinsurance and capital market experience of the principals of Pillar Holdings. We have concluded that both Pillar Holdings and the Funds, or collectively, the “Pillar Investments,” represent variable interest entities and that we are not the primary beneficiary, as we do not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, the Pillar Investments are not consolidated and are accounted for under the equity method of accounting. Our potential maximum loss in the Pillar Investments is limited to our cumulative net investment. As of December 31, 2018, our carrying value in the Pillar Investments, as determined under the equity method of accounting, was $193.6 million, which is net of returns of capital received from the Pillar Investments.
In July 2013, AIHL invested $250.0 million in Ares Management LLC, or “Ares,” an asset manager, in exchange for a 6.25 percent equity stake in Ares, with an agreement to engage Ares to manage up to $1.0 billion in certain investment strategies. In May 2014, Ares completed an initial public offering of its common units. Upon completion of the initial public offering, Alleghany’s equity investment in Ares converted into limited partnership interests in certain Ares subsidiaries that were convertible into Ares common units. On March 15, 2018, most of AIHL’s limited partnership interests were converted into Ares common units. As a result of the conversion and with respect to the limited partnership interests that were converted into Ares common units, AIHL: (i) reclassified its converted interests from other invested assets to equity securities; (ii) increased its carrying value to $208.2 million to reflect the fair value of Ares common units; and (iii) recorded the $45.7 million increase in carrying value as a realized capital gain as of March 15, 2018. As a result of the conversion and with respect to the unconverted limited partnership interests, AIHL: (i) changed its accounting method from the equity method to fair value; (ii) increased its carrying value to $58.7 million to reflect the fair value of Ares limited partnership interests; and (iii) recorded the $12.9 million increase in carrying value as a component of net investment income as of March 15, 2018. On September 24, 2018, AIHL’s remaining Ares limited partnership interests were
converted into Ares common units and, as a result, AIHL reclassified the remaining $56.9 million of its converted interests from other invested assets to equity securities.
$33.7 million of term loans at Concord primarily related to borrowings to finance Alleghany Capital’s acquisition of Concord;
Investment Strategy and Holdings. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize our risk-adjusted, after-tax rate of return. Our investment decisions are guided mainly by the nature and timing of expected liability payouts, management’s forecast of cash flows and the possibility of unexpected cash demands, for example, to satisfy claims due to catastrophe losses. Our consolidated investment portfolio currently consists mainly of highly rated and liquid debt and equity securities listed on national securities exchanges. The overall credit quality of the debt securities portfolio is measured using the lowest rating of S&P, Moody’s or Fitch. In this regard, the overall weighted-average credit quality rating of our debt securities portfolio as of December 31, 2018 and 2017 was AA-. Although a portion of our debt securities, which consist predominantly of municipal bonds,
(1) Consists of $167.8 million of securities rated BB / Ba, $205.3 million of securities rated B, $34.7 million of securities rated CCC, $0.4 million of securities rated CC, $3.3 million of securities rated below CC and $105.1 million of not rated securities.
Effective duration measures a portfolio’s sensitivity to changes in interest rates. In this regard, as of December 31, 2018 and 2017, our debt securities portfolio had an effective duration of approximately 4.2 years and 4.4 years, respectively. As of December 31, 2018, approximately $3.0 billion, or 25.2 percent, of our debt securities portfolio represented securities with maturities of five years or less. See Note 4(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for additional detail on the contractual maturities of our consolidated debt securities portfolio. We may increase the proportion of our debt securities portfolio held in securities with maturities of more than five years should the yields of these securities provide, in our judgment, sufficient compensation for their increased risk. We do not believe that this strategy would reduce our ability to meet ongoing claim payments or to respond to significant catastrophe losses.
In the event paid losses accelerate beyond the ability of our reinsurance and insurance subsidiaries to fund these paid losses related to current cash balances, current operating cash flow, dividend and interest receipts and security maturities, we would need to liquidate a portion of our investment portfolio, make capital contributions to our reinsurance and insurance subsidiaries, and/or arrange for financing. Strains on liquidity could result from: (i) the occurrence of several significant catastrophe events in a relatively short period of time; (ii) the sale of investments into a depressed marketplace to fund these paid losses; (iii) the uncollectibility of reinsurance recoverables on these paid losses; (iv) the significant decrease in the value of collateral supporting reinsurance recoverables; or (v) a significant reduction in our net premium collections.
On a consolidated basis, our invested assets decreased to approximately $17.5 billion as of December 31, 2018 from approximately $18.8 billion as of December 31, 2017, primarily reflecting depreciation in the value of our debt securities portfolio due to an increase in interest rates and credit spreads in 2018, contributions to Alleghany Capital to fund the acquisitions of Concord and Hirschfeld, repurchases of shares of our common stock and depreciation of our equity securities portfolio, all as discussed above. The special dividend on our common stock was funded by the proceeds from the sale of PacificComp.
Although we are responsible for the determination of the fair value of our financial assets and the supporting methodologies and assumptions, we employ third-party valuation service providers to gather, analyze and interpret market information and derive fair values based upon relevant methodologies and assumptions for individual instruments. When those providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting a quote, which is generally non-binding, from brokers who are knowledgeable about these securities or by employing widely accepted valuation models.
debt securities except U.S. Government obligations, and currency rates for certain foreign government obligations and foreign corporate bonds denominated in foreign currencies. Fair values are determined using a market approach that relies on the securities’ relationships to quoted prices for similar assets in active markets, as well as the other inputs described above. In determining the fair values for the vast majority of CMBS and other asset-backed securities, as well as a small portion of RMBS, an income approach is used to corroborate and further support the fair values determined by the market approach. The income approach primarily involves developing a discounted cash flow model using the future projected cash flows of the underlying collateral, and the terms of the security. Level 2 assets generally include short-term investments and most debt securities. Our Level 2 liabilities consist of the Senior Notes.
The business of our reinsurance and insurance subsidiaries exposes them to losses related to various catastrophe events. In a catastrophe event, losses related to many insureds across multiple lines of business may result directly or indirectly from such single occurrence. Our reinsurance and insurance subsidiaries take certain measures to mitigate the impact of catastrophe events through various means including considering catastrophe risks in their underwriting and pricing decisions, purchasing reinsurance, monitoring and modeling accumulated exposures and managing exposure in key geographic zones and product lines that are prone to catastrophe events.
We evaluate catastrophe events and assess the probability of occurrence and magnitude through the use of industry recognized models and other techniques. We supplement these models by judgmentally interpreting and adjusting when appropriate the modeled output and by periodically monitoring the exposure risks of our operations. There is no single standard methodology to project possible losses related to catastrophe exposures. Further, there are no industry standard assumptions used in projecting these losses, and the form and quality of the data obtained, including data obtained from insureds and ceding companies, and used in these models are not uniformly compatible with the data requirements of all models. Therefore, the use of different methodologies and assumptions could materially change the projected losses. Finally, these modeled losses may not be comparable with estimates made by other companies.
The following is an overview of such modeled PMLs from property, engineering, marine and energy exposures and the associated natural perils that we deem most significant. The estimated amount of these modeled losses are presented for both a 100 year return period (having a likelihood of being exceeded in any single year of 1.0 percent) and a 250 year return period (having a likelihood of being exceeded in any single year of 0.4 percent). These modeled losses are presented in two ways: (i) gross catastrophe losses; and (ii) after-tax net catastrophe costs (that is, gross losses, net of reinsurance, net reinstatement premiums and taxes). The reduction for reinsurance assumes that all reinsurers fulfill their obligations in accordance with contract terms.
In March 2017, the FASB issued guidance that reduces the amortization period for the premium on certain purchased callable debt securities to the earliest call date. The guidance applies specifically to noncontingent call features that are callable at a predetermined and fixed price and date. The accounting for purchased callable debt securities held at a discount is not affected. This guidance is effective in the first quarter of 2019 for public entities with early adoption permitted. We adopted this guidance in the fourth quarter of 2017 and recorded a cumulative effect reduction of approximately $13 million directly to opening 2017 retained earnings and an offsetting increase in opening 2017 accumulated other comprehensive income. The implementation did not have a material impact on our results of operations and financial condition. See Note 10(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements & Supplementary Data” of this Form 10-K for further information on accumulated other comprehensive income.
In January 2016, the FASB issued guidance that changes the recognition and measurement of certain financial instruments. This guidance requires investments in equity securities (except those accounted for under the equity method of accounting, but including partnership investments not accounted for under the equity method) to be measured at fair value with changes in fair value recognized in net earnings. For equity securities that do not have readily determinable fair values, measurement may be at cost, adjusted for any impairment and changes resulting from observable price changes for a similar investment of the same issuer. This guidance also changes the presentation and disclosure of financial instruments by: (i) requiring that financial instrument disclosures of fair value use the exit price notion; (ii) requiring separate presentation of financial assets and financial liabilities by measurement category and form, either on the balance sheet or the accompanying notes to the financial statements; (iii) requiring separate presentation in other comprehensive income for the portion of the change in a liability’s fair value resulting from instrument-specific credit risk when an election has been made to measure the liability at fair value; and (iv) eliminating the requirement to disclose the methods and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet. This guidance is effective for fiscal years beginning after December 15, 2017 for public entities, including interim periods within those fiscal years. Except for the change in presentation for instrument-specific credit risk, this guidance does not permit early adoption. We adopted this guidance in the first quarter of 2018. As of January 1, 2018, approximately $736 million of net unrealized gains of equity securities, net of deferred taxes, were reclassified from accumulated other comprehensive income to retained earnings. Subsequently, all changes in unrealized gains or losses of equity securities, net of deferred taxes, were presented in the Consolidated Statements of Earnings rather than the Consolidated Statements of Comprehensive Income, under the caption “change in the fair value of equity securities.” Results arising from partnership investments, whether accounted for under the equity method or at fair value, continue to be reported as a component of net investment income. The implementation did not have a material impact on our financial condition. See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements & Supplementary Data” of this Form 10-K for further information on Alleghany’s equity securities, and Note 10(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements & Supplementary Data” of this Form 10-K for further information on accumulated other comprehensive income.
In February 2016, the FASB issued guidance on leases. Under this guidance, a lessee is required to recognize lease liabilities and corresponding right-of-use assets for leases with terms of more than one year, whereas under current guidance, a lessee is only required to recognize assets and liabilities for those leases qualifying as capital leases. This guidance also requires new disclosures about the amount, timing and uncertainty of cash flows arising from leases. The accounting by lessors is to remain largely unchanged. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. A modified retrospective transition approach is required for all leases in existence as of, or entered into after, the beginning of the earliest comparative period presented in the financial statements. We will adopt this guidance in the first quarter of 2019. As of January 1, 2019, we estimate that the adoption of this guidance will result in recognition of an additional right-of-use asset of approximately $0.2 billion and a corresponding lease liability of $0.2 billion. See Note 12(b) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for further information on Alleghany’s leases.
In January 2017, the FASB issued guidance that simplifies the subsequent measurement of goodwill. Under this guidance, if an initial qualitative assessment indicates that the fair value of an operating subsidiary may be less than its carrying amount, an impairment charge is recognized for the amount by which the carrying amount of the operating subsidiary exceeds its estimated fair value. Any resulting impairment loss recognized cannot exceed the total amount of goodwill associated with the operating subsidiary. This guidance is effective in the first quarter of 2020 for public entities, with early adoption permitted. We will adopt this guidance in the first quarter of 2020 and do not currently believe that the implementation will have a material impact on our results of operations and financial condition. See Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for further information on our goodwill.
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, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 20, 2019 expressed an unqualified opinion thereon.
As discussed in Note 1(r) to the consolidated financial statements, the Company changed its method for accounting for the recognition and measurement of certain financial instruments in 2018.
a 45 percent equity interest in Wilbert Funeral Services, Inc. (“Wilbert”), a provider of products and services for the funeral and cemetery industries and precast concrete markets, headquartered in Overland Park, Kansas; and
CHECO Holdings, LLC (“Concord”), a hotel management and development company, headquartered in Raleigh, North Carolina.
In addition, Alleghany owns certain other holding-company investments. Alleghany’s wholly-owned subsidiary, Stranded Oil Resources Corporation (“SORC”), is an exploration and production company focused on enhanced oil recovery, headquartered in Golden, Colorado. Alleghany’s wholly-owned subsidiary, Alleghany Properties Holdings LLC (“Alleghany Properties”), owns and manages certain properties in the Sacramento, California region. Alleghany’s public equity investments are managed primarily through Alleghany’s wholly-owned subsidiary Roundwood Asset Management LLC.
The accompanying consolidated financial statements include the results of Alleghany and its wholly-owned and majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”). All material inter-company balances and transactions have been eliminated in consolidation.
Commercial mortgage loans are carried at unpaid principal balance, less allowance for loan losses. The allowance for loan losses is a valuation allowance for incurred credit losses when management believes the uncollectibility of a loan balance is probable. Subsequent recoveries, if any, are credited to the allowance. Interest income on loans is accrued as earned.
Reinsurance is used to mitigate the exposure to losses, manage capacity and protect capital resources. Reinsuring loss exposures does not relieve a ceding entity from its obligations to policyholders and cedants. Reinsurance recoverables (including amounts related to incurred but not reported (“IBNR”) claims) and ceded unearned premiums are reported as assets. To minimize exposure to losses related to a reinsurer’s inability to pay, the financial condition of such reinsurer is evaluated initially upon placement of the reinsurance and periodically thereafter. In addition to considering the financial condition of a reinsurer, the collectability of the reinsurance recoverables is evaluated (and where appropriate, whether an allowance for estimated uncollectible reinsurance recoverables is to be established) based upon a number of other factors. Such factors include the amounts outstanding, length of collection periods, disputes, any collateral or letters of credit held and other relevant factors. To the extent that an allowance for uncollectible reinsurance recoverable is established, amounts deemed to be uncollectible are written off against the allowance for estimated uncollectible reinsurance recoverables. Alleghany currently has no allowance for uncollectible reinsurance recoverables.
See Note 5 for additional information on reinsurance ceded and reinsurance recoverables.
Each of Alleghany’s reinsurance and insurance subsidiaries establishes reserves on its balance sheet for unpaid loss and LAE related to its property and casualty reinsurance and insurance contracts. As of any balance sheet date, there are claims that have not yet been reported, and some claims may not be reported for many years after the date a loss occurs. As a result of this historical pattern, the liability for unpaid loss and LAE includes significant estimates for IBNR claims. Additionally, reported claims are in various stages of the settlement process. Each claim is settled individually based upon its merits, and certain claims may take years to settle, especially if legal action is involved. As a result, the liabilities for unpaid loss and LAE include significant judgments, assumptions and estimates made by management related to the actual ultimate losses that will arise from the claims.
See Note 6 and Note 12(c) for additional information on loss reserves.
Certain prior year amounts have been reclassified to conform to the 2018 presentation of the financial statements.
In February 2018, the Financial Accounting Standards Board (“FASB”) issued guidance on certain tax effects caused by the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). The Tax Act, among other things, reduced the U.S. corporate federal income tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018, for the 2018 tax year. Under such circumstances, GAAP requires that the value of deferred tax assets and liabilities be reduced through tax expense. The new guidance provides an option to reclassify any stranded tax amounts that remain in accumulated other comprehensive income to retained earnings, either retrospectively or at the beginning of the period in which the adoption is elected. This guidance became effective in the first quarter of 2018 for public entities, with early adoption permitted in 2017. Alleghany adopted this new guidance in the first quarter of 2018 and has elected to reclassify stranded tax amounts that remain in accumulated other comprehensive income, in the amount of approximately $135 million, to retained earnings as of January 1, 2018. See Note 10(b) for additional information on accumulated other comprehensive income. See Note 9 for additional information on the Tax Act and its impact on Alleghany.
In March 2017, the FASB issued guidance that reduces the amortization period for the premium on certain purchased callable debt securities to the earliest call date. The guidance applies specifically to noncontingent call features that are callable at a predetermined and fixed price and date. The accounting for purchased callable debt securities held at a discount is not affected. This guidance is effective in the first quarter of 2019 for public entities with early adoption permitted. Alleghany adopted this guidance in the fourth quarter of 2017 and recorded a cumulative effect reduction of approximately $13 million directly to opening 2017 retained earnings and an offsetting increase in opening 2017 accumulated other comprehensive income. The implementation did not have a material impact on Alleghany’s results of operations and financial condition. See Note 10(b) for further information on accumulated other comprehensive income.
In January 2016, the FASB issued guidance that changes the recognition and measurement of certain financial instruments. This guidance requires investments in equity securities (except those accounted for under the equity method of accounting, but including partnership investments not accounted for under the equity method) to be measured at fair value with changes in fair value recognized in net earnings. For equity securities that do not have readily determinable fair values, measurement may be at cost, adjusted for any impairment and changes resulting from observable price changes for a similar investment of the same issuer. This guidance also changes the presentation and disclosure of financial instruments by: (i) requiring that financial instrument disclosures of fair value use the exit price notion; (ii) requiring separate presentation of financial assets and financial liabilities by measurement category and form, either on the balance sheet or the accompanying notes to the financial statements; (iii) requiring separate presentation in other comprehensive income for the portion of the change in a liability’s fair value resulting from instrument-specific credit risk when an election has been made to measure the liability at fair value; and (iv) eliminating the requirement to disclose the methods and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet. This guidance is effective for fiscal years beginning after December 15, 2017 for public entities, including interim periods within those fiscal years. Except for the change in presentation for instrument-specific credit risk, this guidance does not permit early adoption. Alleghany adopted this guidance in the first quarter of 2018. As of January 1, 2018, approximately $736 million of net unrealized gains of equity securities, net of deferred taxes, were reclassified from accumulated other comprehensive income to retained earnings. Subsequently, all changes in unrealized gains or losses of equity securities, net of deferred taxes, were presented in the Consolidated Statements of Earnings rather than the Consolidated Statements of Comprehensive Income, under the caption “change in the fair value of equity securities.” Results arising from partnership investments, whether accounted for under the equity method or at fair value, continue to be reported as a component of net investment income. The implementation did not have a material impact on Alleghany’s financial condition. See Note 4 for further information on Alleghany’s equity securities, and Note 10(b) for further information on accumulated other comprehensive income.
In May 2014, the FASB, together with the International Accounting Standards Board, issued guidance on the recognition of revenue from contracts with customers. Under this guidance, revenue is recognized as the transfer of goods and services to customers takes place and in amounts that reflect the payment or payments that are expected to be received from the customers for those goods and services. This guidance also requires new disclosures about revenue. Revenues related to insurance and reinsurance contracts and revenues from investments are not impacted by this guidance, whereas noninsurance revenues arising from the sale of manufactured goods and services is generally included within the scope of this guidance. This guidance, and all related amendments, became effective in the first quarter of 2018 for public entities, with early adoption permitted in 2017. Alleghany adopted this guidance in the first quarter of 2018 using the modified retrospective transition approach and the implementation did not have a material impact on Alleghany’s results of operations and financial condition. See Note 13 for further information on Alleghany’s noninsurance revenues.
In February 2016, the FASB issued guidance on leases. Under this guidance, a lessee is required to recognize lease liabilities and corresponding right-of-use assets for leases with terms of more than one year, whereas under current guidance, a lessee is only required to recognize assets and liabilities for those leases qualifying as capital leases. This guidance also requires new disclosures about the amount, timing and uncertainty of cash flows arising from leases. The accounting by lessors is to remain largely unchanged. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. A modified retrospective transition approach is required for all leases in existence as of, or entered into after, the beginning of the earliest comparative period presented in the financial statements. Alleghany will adopt this guidance in the first quarter of 2019. As of January 1, 2019, Alleghany
estimates that the adoption of this guidance will result in recognition of an additional right-of-use asset of approximately $0.2 billion and a corresponding lease liability of $0.2 billion. See Note 12(b) for further information on Alleghany’s leases.
In June 2016, the FASB issued guidance on credit losses. Under this guidance, a company is required to measure all expected credit losses on loans, reinsurance recoverables and other financial assets accounted for at cost or amortized cost, as applicable. Estimates of expected credit losses are to be based on historical experience, current conditions and reasonable and supportable forecasts. Credit losses for securities accounted for on an AFS basis are to be measured in a manner similar to GAAP as currently applied and cannot exceed the amount by which the fair value is less than the amortized cost. Credit losses for all financial assets are to be recorded through an allowance for credit losses. Subsequent reversals in credit loss estimates are permitted and are to be recognized in earnings. This guidance also requires new disclosures about the significant estimates and judgments used in estimating credit losses, as well as the credit quality of financial assets. This guidance is effective in the first quarter of 2020 for public entities, with early adoption permitted. Alleghany will adopt this guidance in the first quarter of 2020 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition. See Note 4 and 5(b) for further information on Alleghany’s investments and reinsurance recoverables, respectively.
In August 2017, the FASB issued guidance that simplifies the requirements to achieve hedge accounting, better reflects the economic results of hedging in the financial statements and improves the alignment between hedge accounting and a company’s risk management activities. This guidance is effective in the first quarter of 2019 for public entities, with early adoption permitted. Alleghany will adopt this guidance in the first quarter of 2019 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
In August 2018, the FASB issued guidance that changes the financial statement disclosure requirements for measuring fair value. With respect to financial instruments classified as “Level 3” in the fair value disclosure hierarchy, the guidance requires certain additional disclosures for public entities related to amounts included in other comprehensive income and significant unobservable inputs used in the valuation, while removing disclosure requirements related to an entity’s overall valuation processes. The guidance also removes certain disclosure requirements related to transfers between financial instruments classified as “Level 1” and “Level 2” and provides clarification on certain other existing disclosure requirements. This guidance is effective for interim and annual periods beginning after December 15, 2019, with early adoption permitted with respect to any eliminated or modified disclosures. Alleghany will adopt this guidance in the first quarter of 2020 and does not currently believe that the implementation will have a material impact on its results of operations and financial condition.
On October 1, 2018, Alleghany Capital acquired approximately 85 percent of the equity in Concord for $136.6 million, consisting of $68.6 million in cash paid on October 1, 2018, $38.2 million of potential contingent consideration based on future profitability and $29.8 million of incremental debt. In connection with the acquisition, Alleghany recorded $83.0 million of goodwill and $70.8 million of finite-lived intangible assets related primarily to customer relationships.
On February 7, 2018, W&W|AFCO Steel acquired the outstanding equity of Hirschfeld, a fabricator of steel bridges and structural steel for stadiums, airports and other large commercial and industrial projects, for $109.1 million, consisting of $94.4 million in cash and $14.7 million of incremental debt. The $94.4 million paid by W&W|AFCO Steel was funded by capital contributions from Alleghany and noncontrolling interests of $75.5 million and $18.9 million, respectively. In connection with the acquisition, Alleghany completed the process of determining the fair value of acquired assets and liabilities in the fourth quarter of 2018, and recorded $3.0 million of goodwill and $9.4 million of finite-lived intangible assets related primarily to customer relationships.
On April 15, 2016, Alleghany Capital acquired an additional 50 percent of Jazwares’ outstanding equity for $162.8 million, bringing its equity ownership interest to 80 percent and, as of that date, the results of Jazwares have been included in Alleghany’s consolidated results. Prior to April 15, 2016, Jazwares was accounted for under the equity method of accounting. The $162.8 million purchase price includes $122.1 million in cash paid on April 18, 2016 and $40.7 million of potential contingent consideration based on
future profitability, which was subsequently settled, effective December 31, 2017, for $20.9 million less. The $20.9 million was recorded as a realized gain in 2017. In connection with the acquisition, $130.0 million, $52.4 million and $89.7 million of goodwill, indefinite-lived intangible assets and finite-lived intangible assets, respectively, were recorded. Indefinite-lived intangible assets related to trade name and finite-lived intangible assets related to license agreements, customer relationships and owned content.
Acquisitions made by Kentucky Trailer in 2014, 2015 and 2018, including the acquisition of a controlling interest in a manufacturer of aluminum feed transportation equipment based in Cedar Rapids, Iowa on December 28, 2018;
In most instances, trade names and state and foreign insurance licenses have an indefinite useful life. The economic useful lives of significant intangible assets in the reinsurance and insurance segments are as follows: agency relationships - 15 years; brokerage and reinsurance relationships - 15 years; renewal rights - between 3 and 14 years; loss and LAE reserves - 15 years; and leases - 10 years. The economic useful life of license agreements is 8 years and of customer relationships is between 5 and 10 years.
The following table presents the carrying value and estimated fair value of Alleghany’s consolidated financial instruments as of December 31, 2018 and 2017:
(1) This table includes debt and equity securities, as well as partnership and non-marketable equity investments carried at fair value that are included in other invested assets. This table excludes investments accounted for using the equity method and commercial mortgage loans that are carried at unpaid principal balance. The fair value of short-term investments approximates amortized cost. The fair value of all other categories of investments is discussed below.
In addition to the $58.7 million of Ares-related other invested assets transferred into Level 3, in 2018, Alleghany transferred into Level 3 $6.3 million of financial instruments, principally due to a decrease in observable inputs related to the valuation of such assets and, specifically, a decrease in broker quotes. Of the $6.3 million of transfers, $4.3 million related to preferred stock, $1.9 million related to corporate bonds and $0.1 million related to other invested assets. There were no other material transfers between Levels 1, 2 or 3 in 2018.
The following tables present reconciliations of the changes during 2018 and 2017 in Level 3 assets measured at fair value:
(1) Includes partnership and non-marketable equity investments accounted for at fair value.
The following tables present the amortized cost or cost and the fair value of AFS securities as of December 31, 2018 and 2017:
(1) Includes $1,266.9 million and $1,101.3 million of collateralized loan obligations as of December 31, 2018 and 2017, respectively.
The following table presents net investment income for 2018, 2017 and 2016:
(1) See Note 4(i) for discussion of the Pillar Investments, as defined therein, and limited partnership interests in certain subsidiaries of Ares.
As of December 31, 2018, non-income producing invested assets were insignificant.
The following table presents increases in the fair value of equity securities for 2018:
The proceeds from sales of debt and equity securities were $5.3 billion, $8.3 billion and $7.0 billion for 2018, 2017 and 2016, respectively.
The SORC assets that were written-down in 2016 related specifically to SORC’s acquisition of a certain legacy oil field for the sole purpose of applying enhanced oil recovery techniques. After completing construction of its underground facility in 2014, SORC commenced its drilling program in 2015. The drilling program, however, was delayed by third-party equipment problems that have since been corrected as well as a longer than expected trial-and-error process determining the optimum well completion technique for the reservoir, and efforts to address a lack of vertical permeability in the reservoir formation. SORC engaged a third-party petroleum engineering firm to provide an assessment of its oil-recovery prospects and based on this assessment and other factors including oil prices, SORC wrote-down its legacy oil field assets to estimated fair value as of December 31, 2016.
Alleghany holds its debt securities as AFS and, as such, these securities are recorded at fair value. Alleghany continually monitors the difference between amortized cost and the estimated fair value of its debt investments, which involves uncertainty as to whether declines in value are temporary in nature. The analysis of a security’s decline in value is performed in its functional currency. If the decline is deemed temporary, Alleghany records the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, Alleghany writes its amortized cost-basis down to the fair value of the security and records an OTTI loss on its statement of earnings. In addition, any portion of such decline related to a debt security that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than charged against earnings.
in earnings is the non-credit related portion, which is recorded as a component of other comprehensive income.
The following tables present gross unrealized losses and related fair values for Alleghany’s AFS securities, grouped by duration of time in a continuous unrealized loss position, as of December 31, 2018 and 2017:
As of December 31, 2018, Alleghany held a total of 2,226 debt securities that were in an unrealized loss position, of which 850 securities were in an unrealized loss position continuously for 12 months or more. The unrealized losses associated with these debt securities consisted of losses related primarily to U.S. Government obligations, U.S. corporate bonds, foreign corporate bonds and RMBS.
As of December 31, 2018, the vast majority of Alleghany’s debt securities were rated investment grade, with 4.4 percent of debt securities having issuer credit ratings that were below investment grade or not rated, compared with 5.3 percent as of December 31, 2017.
Investments with fair values of approximately $2.0 billion as of December 31, 2018, the substantial majority of which were debt securities and equity securities, were deposited with governmental authorities as required by law.
In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited (“Pillar Holdings”), a Bermuda- based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities. Additionally, TransRe invested $175.0 million and AIHL invested $25.0 million in limited partnership funds managed by Pillar Holdings (the “Funds”). The objective of the Funds is to create portfolios with attractive risk-reward characteristics and low correlation with other asset classes, using the extensive reinsurance and capital market experience of the principals of Pillar Holdings. Alleghany has concluded that both Pillar Holdings and the Funds (collectively, the “Pillar Investments”) represent variable interest entities and that Alleghany is not the primary beneficiary, as it does not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, the Pillar Investments are not consolidated and are accounted for under the equity method of accounting. Alleghany’s potential maximum loss in the Pillar Investments is limited to its cumulative net investment. As of December 31, 2018, Alleghany’s carrying value in the Pillar Investments, as determined under the equity method of accounting, was $193.6 million, which is net of returns of capital received from the Pillar Investments.
The following table presents information regarding concentration of Alleghany’s reinsurance recoverables and the ratings profile of its reinsurers as of December 31, 2018:
Reinsured loss and LAE ceded included in Alleghany’s consolidated statements of earnings were $628.2 million, $777.4 million and $325.8 million for 2018, 2017 and 2016, respectively.
RSUI reinsures its property lines of business through a program consisting of surplus share treaties, facultative placements, per risk and catastrophe excess-of-loss treaties. RSUI’s catastrophe reinsurance program and property per risk reinsurance program run on an annual basis from May 1 to the following April 30 and portions expired on April 30, 2018. Both programs were renewed on May 1, 2018 with substantially similar terms as the expired programs.
In the third quarter of 2015, AIHL Re and CapSpecialty entered into an intercompany reinsurance contract, effective July 1, 2015, pursuant to which AIHL Re provides CapSpecialty with coverage primarily for adverse development on certain net loss and allocated LAE in excess of its carried reserves at June 30, 2015. AIHL Re’s commitments are intended to cover the statutory collateral requirements at CapSpecialty, if and when necessary, and AIHL Re’s obligations are subject to an aggregate limit of $50.0 million. In connection with such intercompany reinsurance agreement, Alleghany and AIHL Re entered into a contract whereby Alleghany will guarantee the recoverable balances owed to CapSpecialty from AIHL Re up to $50.0 million. The above agreements had no impact on Alleghany’s consolidated results of operations and financial condition.
The following table presents the activity in the liability for loss and LAE in 2018, 2017 and 2016:
(3) Includes paid loss and LAE, net of reinsurance, related to commutations.
(1) Primarily reflects favorable prior accident year loss reserve development related to Hurricane Harvey in the 2017 accident year and catastrophes in the 2016 accident year, partially offset by unfavorable prior accident year loss reserve development related to Hurricanes Maria and Irma in the 2017 accident year.
(3) Reflects favorable prior accident year loss reserve development related to several catastrophes in the 2010 through 2015 accident years.
(5) Reflects favorable prior accident year loss reserve development primarily in the 2011 through 2016 accident years.
(10) Primarily reflects favorable prior accident year loss reserve development in: (i) longer-tailed professional liability and general liability lines of business in the 2003 through 2012 accident years; and (ii) shorter-tailed casualty lines of business in the 2010 through 2014 accident years; partially offset by unfavorable prior accident year loss reserve development in shorter-tailed casualty lines of business in the 2015 and 2016 accident years.
(13) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess lines of business in the 2005 through 2011 accident years.
(14) Primarily reflects favorable prior accident year loss reserve development in the umbrella/excess, general liability and professional liability lines of business in the 2006 through 2012 accident years.
(16) Primarily reflects favorable catastrophe prior accident year loss reserve development in the 2016 accident year, partially offset by unfavorable prior accident year property loss reserve development in the binding authority lines of business primarily in the 2015 and 2016 accident years.
(17) Includes favorable prior accident year loss reserve development of ($20.6) million related to Super Storm Sandy in 2012 and various other smaller amounts primarily in the non-catastrophe property lines of business in recent accident years.
Reinsurance Segment - Casualty & other - Shorter-Tailed Lines of Business(1)
(1) Primarily represents the following reinsurance lines of business: ocean marine and aviation; auto liability; accident and health; mortgage reinsurance; surety; and credit.
(1) Includes unallocated LAE, which aggregate to 1.1 percent of gross loss and LAE reserves as of December 31, 2018. Net loss and LAE reserves by component are shown in the preceding tables, and consolidated gross loss and LAE reserves is presented in the Consolidated Balance Sheets.
The following table presents supplemental information about average historical loss and LAE duration, net of reinsurance, as of December 31, 2018.
On November 23, 2009, TransRe completed a public offering of $350.0 million aggregate principal amount of its 8.00% senior notes due on November 30, 2039 (the “2039 Senior Notes”). The 2039 Senior Notes are unsecured and unsubordinated general obligations of TransRe and are not guaranteed by Alleghany. Interest on the 2039 Senior Notes is payable semi-annually. The terms of the 2039 Senior Notes permit redemption prior to their maturity. The indentures under which the 2039 Senior Notes were issued contain covenants that impose conditions on TransRe’s ability to create liens on, or engage in sales of, the capital stock of certain of its subsidiaries, including Transatlantic Reinsurance Company, TransRe Zurich Ltd. or Fair American Insurance and Reinsurance Company.
The debt associated with Alleghany Capital’s operating subsidiaries totaled $284.5 million and $101.0 million as of December 31, 2018 and 2017, respectively. As of December 31, 2018, the $284.5 million includes:
$66.6 million of term loans at Kentucky Trailer primarily related to borrowings to finance small acquisitions, its December 28, 2018 acquisition of a controlling interest in a manufacturer of aluminum feed transportation equipment and borrowings under its available credit facility;
$8.2 million of borrowings by IPS under its available credit facility.
The following table presents income tax expense (benefit) for 2018, 2017 and 2016:
The decrease in the effective tax rate in 2018 from 2017 primarily reflects the decrease in the U.S. corporate federal income tax rate due to the Tax Act, as well as new limitations on certain deductions as a result of the Tax Act and a tax benefit associated with the sale of PacificComp.
The effective tax rate in 2017 compared with 2016 primarily reflected income tax benefits from taxable losses arising from Hurricanes Irma, Harvey and Maria in 2017 and, to a lesser extent, a tax benefit associated with the sale of PacificComp, as well as prior period income tax expense adjustments in 2016, which included $16.1 million of out-of-period reductions to current and deferred TransRe tax assets recorded in 2016 that related primarily to periods prior to Alleghany’s merger with TransRe in 2012.
A valuation allowance is provided against deferred tax assets when, in the opinion of management, it is more likely than not that a portion of the deferred tax asset will not be realized. As of December 31, 2018 and 2017, Alleghany recognized $23.5 million and $18.3 million, respectively, of deferred tax assets for certain state net operating and capital loss carryovers, and a valuation allowance of $23.5 million and $18.3 million, respectively, has been established against these deferred tax assets as Alleghany does not currently anticipate it will generate sufficient income in these states to absorb such loss carryovers.
Alleghany’s income tax return is currently under examination by the Internal Revenue Service for the 2016 tax year. The following table presents the tax years of Alleghany and TransRe tax returns that remain subject to examination by major tax jurisdictions as of December 31, 2018.
In July 2014, the Alleghany Board of Directors authorized the repurchase of shares of Common Stock at such times and at prices as management determines to be advisable, up to an aggregate of $350.0 million (the “2014 Repurchase Program”). In November 2015, the Alleghany Board of Directors authorized the repurchase, upon the completion of the 2014 Repurchase Program, of additional shares of Common Stock at such times and at prices as management determines to be advisable, up to an aggregate of $400.0 million (the “2015 Repurchase Program”). In June 2018, the Alleghany Board of Directors authorized, upon the completion of the 2015 Repurchase Program, the repurchase of additional shares of Common Stock at such times and at prices as management determines to be advisable, up to an aggregate of $400.0 million (the “2018 Repurchase Program”). In the first quarter of 2016, Alleghany completed the 2014 Repurchase Program and subsequent repurchases have been made pursuant to the 2015 Repurchase Program. In the fourth quarter of 2018, Alleghany completed the 2015 Repurchase Program and subsequent repurchases have been made pursuant to the 2018 Repurchase Program. As of December 31, 2018, Alleghany had $271.5 million remaining under its share repurchase authorization.
The following table presents the shares of Common Stock that Alleghany repurchased pursuant to the 2014 Repurchase Program, the 2015 Repurchase Program and the 2018 Repurchase Program, as applicable:
The following table presents a reconciliation of the changes during 2018 and 2017 in accumulated other comprehensive income attributable to Alleghany stockholders:
(1) See Note 1(r) for additional information regarding Alleghany’s adoption of new investment accounting guidance and new guidance on certain tax effects caused by the Tax Act.
The following table presents reclassifications out of accumulated other comprehensive income attributable to Alleghany stockholders during 2018 and 2017:
(1) For 2018, excludes a $45.7 million pre-tax gain from AIHL’s conversion of its limited partnership interests in certain subsidiaries of Ares into Ares common units, and a $35.4 million capital loss due to an impairment charge from the write-down of certain SORC assets arising from a decline in energy prices as of December 31, 2018. See Note 4(i) for additional information. For 2017, excludes an $8.4 million pre-tax gain from the sale of PacificComp, a $20.9 million realized gain on bulk settlement of certain contingent liabilities by Alleghany Capital, a ($4.8) million loss realized from the sale of a SORC legacy oil field on December 29, 2017 and a ($7.9) million write-down of certain Reinsurance Segment assets.
As of December 31, 2018, a maximum amount of $64.9 million was available for dividends by TRC without prior approval of the applicable regulatory authorities.
The statutory net income of Alleghany’s reinsurance and insurance subsidiaries was $263.6 million and $144.4 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018 and 2017, the combined statutory capital and surplus of Alleghany’s reinsurance and insurance subsidiaries was $6.5 billion and $6.9 billion, respectively. As of December 31, 2018, the amount of statutory capital and surplus necessary to satisfy regulatory requirements was not significant in relation to the actual statutory capital and surplus of Alleghany’s reinsurance and insurance companies in the U.S.
The following table presents a reconciliation of the earnings and share data used in the basic and diluted (losses) earnings per share computations for 2018, 2017 and 2016:
Loss and LAE include amounts for risks related to asbestos-related illness and environmental impairment. The following table presents such gross and net reserves as of December 31, 2018 and 2017:
As of December 31, 2018, Alleghany had holdings in energy sector businesses of $385.2 million, comprised of $288.9 million of debt securities, $8.3 million of equity securities and $88.0 million of Alleghany’s equity attributable to SORC.
The reinsurance segment consists of property and casualty reinsurance operations conducted by TransRe’s reinsurance operating subsidiaries and is further reported through two major product lines - property and casualty & other. TransRe provides property and casualty reinsurance to insurers and other reinsurers through brokers and on a direct basis to ceding companies. TransRe also writes a modest amount of property and casualty insurance business, which is included in the reinsurance segment. A significant portion of the premiums earned by TransRe’s operations are generated by offices located in Canada, Europe, Asia, Australia, Africa and those serving Latin America and the Caribbean. Although the majority of the premiums earned by these offices typically relate to the regions where they are located, a significant portion may be derived from other regions of the world, including the U.S. In addition, although a significant portion of the assets and liabilities of these foreign offices generally relate to the countries where ceding companies and reinsurers are located, most investments are located in the country of domicile of these offices.
The Alleghany Capital segment consists of industrial operations, non-industrial operations and corporate operations at the Alleghany Capital level. Industrial operations are conducted through Bourn & Koch, Kentucky Trailer, W&W|AFCO Steel beginning April 28, 2017 (the date on which Alleghany Capital acquired approximately 80 percent of the equity thereof), and a 45 percent equity interest in Wilbert, beginning August 1, 2017 (the date on which Alleghany Capital acquired its equity interest therein). Non-industrial operations are conducted through IPS, Jazwares and Concord beginning October 1, 2018 (the date Alleghany Capital acquired approximately 85 percent of the equity thereof).
(3) Includes amortization associated with deferred acquisition costs of $1,271.4 million, $1,261.7 million and $1,253.2 million for the years ended December 31, 2018, 2017 and 2016, respectively.
(4) Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, change in the fair value of equity securities, net realized capital gains, OTTI losses, noninsurance revenue, other operating expenses, corporate administration, amortization of intangible assets or interest expense. Underwriting profit does not replace earnings before income taxes determined in accordance with GAAP as a measure of profitability. Rather, Alleghany believes that underwriting profit enhances the understanding of its reinsurance and insurance segments’ operating results by highlighting net earnings attributable to their underwriting performance. Earnings before income taxes (a GAAP measure) may show a profit despite an underlying underwriting loss. Where underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. Therefore, Alleghany views underwriting profit as an important measure in the overall evaluation of performance.
Foreign gross premiums written in 2018, 2017 and 2016 were approximately $1.6 billion, $1.5 billion and $1.5 billion, respectively.
Foreign net premiums earned in 2018, 2017 and 2016 were each approximately $1.4 billion. The foreign country in which Alleghany generates the largest amount of premium revenues is the U.K. Net premiums earned by operations in the U.K. in 2018, 2017 and 2016 were $583.8 million, $612.1 million and $622.3 million, respectively.
For Alleghany Capital’s industrial and non-industrial operations, noninsurance revenue consists of the sale of manufactured goods and services. The following table presents noninsurance revenue for the Alleghany Capital segment for 2018, 2017 and 2016:
A large whole account quota share treaty entered into in the fourth quarter of 2015 accounted for approximately 17 percent in 2018, 19 percent in 2017 and 20 percent in 2016 of gross premiums written in the reinsurance segment.
As of December 31, 2018, Alleghany had long-term compensation plans for parent company-level employees and directors. Parent company-level, long-term compensation awards to current employees do not include stock options but consist only of restricted stock awards, including restricted stock units and performance share awards. Parent company-level, long-term compensation awards to non-employee directors consist of annual grants of restricted shares and restricted stock units of Common Stock.
Amounts recognized as compensation expense in the consolidated statements of earnings and comprehensive income with respect to long-term compensation awards under plans for parent company-level employees and non-employee directors were ($12.0) million, $17.1 million and $17.1 million in 2018, 2017 and 2016, respectively. The negative expense for 2018 reflects a reversal of certain long-term incentive compensation expense accruals, driven primarily by the impacts of depreciation in the value of Alleghany’s consolidated debt and equity securities portfolio, as well as significant catastrophe losses incurred at Alleghany’s reinsurance and insurance subsidiaries in 2018. The amount of related income tax (expenses) benefit in the consolidated statements of earnings and comprehensive income with respect to these plans was ($2.5) million, $3.6 million and $6.0 million in 2018, 2017 and 2016, respectively. In 2018, 2017 and 2016, $4.3 million, $7.1 million and $5.7 million of Common Stock at fair market value, respectively, and $17.1 million, $19.3 million and $14.4 million of cash, respectively, was paid by Alleghany under these plans for parent company-level employees and non-employee directors. As noted above, as of December 31, 2018 and 2017, all outstanding awards were accounted for under the fair-value-based method of accounting.
The following is a summary of the parent company-level, long-term compensation plans.
The annual grant to each non-employee director consists of either restricted shares or restricted stock units of Common Stock, at the director’s election. Awards granted to non-employee directors were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2018.
Performance Share Awards - Participants are entitled, at the end of a four-year award period, to a maximum amount equal to the value of one and one-half shares of Common Stock for each performance share issued to them based on market value on the payment date. Payouts are made provided defined levels of performance are achieved. Expenses are recorded based on changes in the fair value of the awards. The fair value is calculated based primarily on the value of Common Stock as of the balance sheet date, the degree to which performance targets have been achieved and the time elapsed with respect to each award period.
TransRe has a Book Value Unit Plan and a Mid-Term Incentive Plan (collectively, the “TransRe Plans”) for the purpose of providing incentives to key employees of TransRe. Under the TransRe Plans, book value units (“BVUs”) and mid-term incentive plan (“MTIP”) awards are issued. BVUs and MTIP awards may only be settled in cash. The fair value of each BVU is calculated as the stockholder’s equity of TransRe, adjusted for certain capital transactions, divided by the adjusted number of BVUs outstanding. BVUs have vesting dates of up to approximately the fourth anniversary of the date of grant. The fair value of MTIP awards is calculated based on underwriting results compared to specified targets. MTIP awards have vesting dates of approximately the second or third anniversary of the date of grant. The BVUs and MTIP awards contain certain restrictions, related to, among other things, forfeiture in the event of termination of employment and transferability. In 2018, 2017 and 2016, TransRe recorded $35.6 million, $46.6 million and $50.7 million, respectively, in compensation expense and a deferred tax benefit of $7.5 million, $9.8 million and $17.7 million, respectively, related to the TransRe Plans.
Long-term incentive plans exist at certain other subsidiaries for the purpose of providing equity-like incentives to key employees. The awards under such plans were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2018.
Alleghany has endorsement split-dollar life insurance policies for its parent company-level officers that are effective during employment, as well as retirement. Premiums are paid by Alleghany and death benefits are split between Alleghany and the beneficiaries of the officers. Death benefits for current employees that inure to the beneficiaries are generally equal to four times the
W&W|AFCO Steel has a funded noncontributory defined benefit plan for certain of its employees. Benefits under W&W|AFCO Steel’s defined benefit plans were frozen as of April 1, 2003. During 2018, W&W|AFCO Steel initiated a plan termination, whereby the obligations related to plan participants currently receiving benefits were annuitized through the purchase of annuity contracts from a third-party life insurance company, and certain other employees were offered lump sum distributions. As of December 31, 2018 and 2017, the projected benefit obligation was $10.0 million and $23.2 million, respectively, and the related fair value of plan assets was $11.7 million and $14.0 million, respectively.
Selected quarterly financial data for 2018 and 2017 are presented below:
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.