“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk” contain disclosures which are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts, and can be identified by the use of words such as “may,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan,” “believe,” “potential,” “should,” “continue” or the negative versions of those words or other comparable words. These forward-looking statements are based upon our current plans or expectations and are subject to a number of uncertainties and risks that could significantly affect current plans, anticipated actions and our future financial condition and results. These statements are not guarantees of future performance, and we have no specific intention to update these statements. The uncertainties and risks include, but are not limited to risks relating to our insurance operating units such as
the willingness and ability of our insurance operating units’ reinsurers to pay reinsurance recoverables owed to them;
As noted above, as of any balance sheet date, not all claims that have occurred have been reported to our insurance operating units, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled by the insurer is referred to as the “claim tail.” Property claims usually have a fairly short claim tail and, absent claim litigation, are reported and settled within no more than a few years of the date they are reported. For short tail lines, the process of recording quarterly and annual liabilities for unpaid losses and LAE is primarily focused on maintaining an appropriate reserve level for reported claims and IBNR, rather than determining an expected loss ratio for the current business. Our insurance operating units provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and as a result, these claims can have a very long claim tail, occasionally extending for decades. In conformity with GAAP, our insurance operating units are not permitted to establish IBNR reserves for catastrophe losses that have not occurred. Therefore, losses related to a significant catastrophe or accumulation of catastrophes in any reporting period could have a material, negative impact on our results during that period. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long tail casualty lines of business, estimation of ultimate liabilities for unpaid losses and LAE is a more complex process and depends on a number of factors, including the line and volume of the business involved. For these reasons, AIHL’s insurance operating units will generally use actuarial projections in setting reserves for all casualty lines of business.
Our insurance operating units continually evaluate the potential for changes, both positive and negative, in their estimates of these liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid losses and LAE established in prior years, these liabilities are periodically analyzed and their expected ultimate cost adjusted, where necessary, to reflect positive or negative development in loss experience and new information, including, for certain catastrophic events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded
liabilities for unpaid losses and LAE, both positive and negative, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior year reserve development. Additional information regarding prior year loss reserve development during the three-year period ended December 31, 2005 is included on pages 42 through 44 of this Form 10-K Report.
We hold our equity and debt securities as available for sale, and as such, these securities are recorded at fair value based on quoted market prices or dealer quotes. We complete a detailed analysis each quarter to assess whether the decline in the fair value of any investment below cost is other than temporary. All securities with an unrealized loss are reviewed, taking into account considerations including the persistence and magnitude of the decline of the issuer, issuer specific financial conditions rather than general market or industry conditions and extraordinary events including negative news releases and rating agency downgrades. A decline in value that is considered to be other than temporary is charged to earnings based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. Risks and uncertainties are inherent in the methodology we use to assess other than temporary declines in value. Risks and uncertainties could include, but are not limited to, incorrect or overly optimistic assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral and unfavorable changes in economic or social conditions, interest rates or credit ratings.
Our consolidated balance sheet as of December 31, 2005 includes goodwill and other intangible assets, net of amortization, of approximately $167.5 million. This amount has been recorded as a result of business acquisitions. Goodwill and other intangible assets are tested annually for impairment. We completed the annual test for impairment during the fourth quarter of 2005 based upon results of operations through September 30, 2005 and determined that there was no indication of impairment. A significant amount of judgment is required in performing goodwill and other intangible assets impairment tests. These tests include estimating the fair value of our operating units and other intangible assets. With respect to goodwill, as required by Statement No. 142, we compare the estimated fair value of our operating units with their respective carrying amounts including goodwill. Under Statement No. 142, fair value refers to the amount for which the entire operating unit may be bought or sold. Our methods for estimating operating unit values include asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. All of these methods involve significant estimates and assumptions.
The following table summarizes the significant sources of our consolidated revenues and costs and expenses (in thousands):
common stock of Burlington Northern were sold by the parent company in 2003 which, along with other investment transactions, generated $62.3 million of pre-tax net gains on investment transactions at the parent company in that year.
The effective tax rate on earnings from continuing operations before income taxes was 22.9 percent in 2005, 31 percent in 2004 and 30.4 percent in 2003. The reduction in the effective tax rate in 2005 from 2004 was due to an increase in tax-exempt interest and income subject to dividend received deductions in 2005.
Represents net premiums earned less loss and loss adjustment expenses and underwriting expenses, all as determined in accordance with GAAP, and does not include interest, dividend and other income or net gains on investment transactions. Underwriting profit (loss) does not replace net income (loss) determined in accordance with GAAP as a measure of profitability; rather, we believe that underwriting profit (loss), which does not include interest, dividend and other income or net gains on investments transactions, enhances the understanding of AIHL’s insurance operating units’ operating results by highlighting net income attributable to their underwriting performance. With the addition of interest, dividend and other income and net gains on investment transactions, reported pre-tax net income (a GAAP measure) may show a profit despite an underlying underwriting loss. Where underwriting losses persist over extended periods, an insurance company’s ability to continue as an ongoing concern may be at risk. Therefore, we view underwriting (loss) profit as an important measure in the overall evaluation of performance.
Includes $320.8 million of unearned premiums which were acquired with RSUI in July 2003 and $169. 9 million of premiums assumed on a net basis.
Of RSUI’s $1.25 billion of estimated gross losses from the 2005 hurricanes, $964.6 million were ceded to RSUI’s reinsurers under all of RSUI’s reinsurance programs. At December 31, 2005, 61 percent of RSUI’s reinsurance receivables were attributable to 2005 hurricane activity. With respect to Hurricane Katrina, of RSUI’s $1.04 billion of estimated gross losses, $837.3 million were ceded to RSUI’s reinsurers under all of RSUI’s reinsurance programs. At December 31, 2005, 53.2 percent of RSUI’s reinsurance receivables were attributable to Hurricane Katrina. The reinsurance recoveries for Hurricane Katrina anticipate the full utilization of RSUI’s catastrophe reinsurance program and significant utilization of the occurrence limits of its surplus share and per risk reinsurance treaties. As a result, should Hurricane Katrina’s losses prove to be greater than currently estimated, RSUI would not have reinsurance coverage under its catastrophe program or significant reinsurance coverage under its other reinsurance programs available for additional loss amounts. After payment of reinsurance reinstatement premiums with respect to its catastrophe and per risk reinsurance treaties, RSUI currently estimates it has in excess of 97 percent of the limits of its catastrophe reinsurance program available for losses from Hurricanes Rita or Wilma or future catastrophe events which occur during the coverage period. At December 31, 2005, RSUI had gross paid losses of $148.7 million related to the 2005 hurricanes. Additional information regarding RSUI’s use of reinsurance and risks related to reinsurance recoverables can be found on pages 17 through 19 and pages 24 and 25 of this Form 10-K Report.
RSUI’s gross premiums written in 2005 increased marginally from 2004, with increases across all lines except for property which was flat and general liability which declined. The aggregate increase in gross premiums written in 2005 reflected improved production in
RSUI’s underwriting expense increased in 2005 from 2004 due to the absence of profit sharing payments under RSUI’s property surplus share treaties, a $5.2 million reversal of profit sharing payments under these treaties and a decrease in incentive compensation accruals. RSUI’s underwriting expense is reduced by commissions that it receives under its reinsurance treaties for ceding premiums to the reinsurers. These payments recognize and offset expenses incurred by RSUI in underwriting and administering the ceded business. RSUI’s property surplus share treaties provide for profit sharing payments by the reinsurers based upon underwriting results of the ceded business. In 2004 and 2003, these profit sharing accruals reduced underwriting expense by $10.2 million and $19.0 million, respectively. As a result of the 2004 and 2005 hurricanes, the underwriting results of the 2004 property surplus share reinsurance treaties deteriorated to a point where the profit sharing payments earned in 2004 and collected in 2005 were eliminated, resulting in a return of $5.2 million of these payments. In view of the 2005 catastrophe losses, RSUI does not expect to have the benefit in 2006 of any profit sharing under the property surplus share treaties. RSUI’s underwriting expense in 2004 and 2003, in addition to profit sharing accruals in these years, reflects amortization of the cost of the unearned premiums acquired with RSUI in the amount of $2.7 million in 2004 and $12.3 million in 2003.
professional liability which experienced modest increases in rates) and decreased rates in its property lines of business primarily due to increased competition. In the 2005 fourth quarter, rates in property lines of business, particularly for coastal property risks, increased from the 2005 third quarter. If rates continue to soften in our casualty lines of business, RSUI may write lower levels of gross premiums written in casualty lines during 2006, since RSUI is expected to write less business when it considers prices inadequate to support acceptable profit margins.
Gross premiums written decreased slightly in 2005 from 2004 reflecting the loss of premiums attributable to the contract surety lines of business that CATA exited in 2005, almost entirely offset by volume growth in CATA’s property and casualty and commercial surety lines of business, in part due to its continued expansion into the excess and surplus markets. Gross premiums written increased in 2004 from 2003 primarily reflecting the expansion of CATA’s business into the excess and surplus markets.
The increase in net premiums earned at CATA in 2004 and 2005 primarily reflects growth in both property and casualty (including in excess and surplus markets) and commercial surety lines and lower reinsurance costs partially offset by the loss of premiums attributable to CATA’s exit from the construction segment of its contract surety line of business. Underwriting expenses decreased in 2005 from 2004 primarily reflecting CATA’s exit from the construction segment of its contract surety line of business in 2005, partially offset by expenses related to CATA’s growth across its other lines of business. Underwriting expenses increased in 2004 from 2003, primarily reflecting the growth of the business, information technology initiatives and personnel costs. The decrease in loss and LAE in 2005 from 2004 reflects the $5.2 million pre-tax release of prior year loss reserves in 2005 (compared with $10.6 million of adverse development in prior year loss reserves in 2004), partially offset by additional 2005 accident year reserve provisions relating to the increase in net premiums earned in 2005.
The increase in net premiums earned at Darwin in 2004 and 2005 primarily reflects growth across all lines of business as well as an increase in retentions under its reinsurance programs. The increase in underwriting expenses at Darwin in 2004 and 2005 primarily reflects organizational build-up expenses incurred to support growth of Darwin’s business. With respect to loss and LAE, the increase in loss and LAE primarily reflects the increase in net premiums earned during this period. As Darwin commenced operations in May 2003, it has limited claims experience on which to base its reserves. Until sufficient claims experience exists, Darwin’s management and outside actuaries primarily use industry data related to the lines of business underwritten by Darwin, and to a lesser extent Darwin’s own claims experience, to establish reserves.
With respect to liabilities for unpaid losses and LAE established in prior years, AIHL’s insurance operating units periodically analyze these liabilities and adjust their expected ultimate cost, where necessary, to reflect positive or negative development in loss experience and new information, including, for certain catastrophic events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid losses and LAE, both positive and negative, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior year reserve development. The following table presents the reserves established in connection with the losses and LAE of AIHL’s insurance operating units on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate losses (including IBNR) and LAE.
Total gross and net loss and LAE reserves increased at December 31, 2005 from December 31, 2004, primarily reflecting an increase in both property and casualty loss and LAE reserves. With respect to property lines of business, the increase in gross and net loss and LAE reserves primarily reflects losses at RSUI due to Hurricanes Katrina, Rita, Dennis and Wilma. The increase in gross and net LAE reserves for the casualty lines of business, which includes, among others, excess and umbrella, directors and officers liability, professional liability, general liability and workers’ compensation, primarily reflects increased premiums earned in directors and officers liability and professional liability and limited paid loss activity for the current and prior casualty accident years. With respect to commercial multiple peril, or “CMP,” lines of business, the increase in gross and net loss and LAE reserves primarily reflects an increase in CMP premiums earned in 2005.
The decrease in gross and net loss and LAE reserves in the surety lines of business reflects CATA’s exit from the construction segment of the contract surety line in early 2005 and favorable loss emergence resulting in a $5.8 million reduction of prior accident year loss reserves. “All Other” lines of business primarily consist of loss and LAE reserves for lines of business discontinued in 2005 and loss reserves acquired in connection with the acquisition of Platte River and Landmark for which the sellers provided loss reserve guarantees. These acquired loss and LAE reserves are ceded 100 percent to the sellers, and as a result, they are not reflected in the above table. The decrease in the gross loss and LAE reserves for “All Other” lines is primarily due to the settlement of losses by the seller of Platte River. Additional information regarding the loss reserve guarantees of the sellers of Platte River and Landmark can be found in Note 5 to our consolidated financial statements set forth in Item 8 of this Form 10-K Report.
The decrease in gross and net surety loss and LAE reserves primarily reflects a decrease in contract surety premiums earned. The decrease in “All Other” gross loss and LAE reserves reflects a $20.0 million decrease in the liabilities for which the seller of Landmark provided loss reserve guarantees, a $13.5 million decrease in the liabilities for which the seller of Platte River provided loss reserve guarantees and a $1.7 million decrease in reserves related to assumed reinsurance written by CATA during the years 1969-1976 as a result of settlement of losses.
Debt Securities Portfolio. The following table reflects investment results for the debt securities portfolio of AIHL and its subsidiaries, on a consolidated basis, for the years ended December 31, 2005, 2004 and 2003 (in thousands, except for percentages):
The following tables indicate the composition of the long-term debt securities portfolio by years until contractual maturity at December 31, 2005 and 2004 (in thousands, except for percentages):
As of December 31, 2005, we owned 6.0 million shares of Burlington Northern, or approximately 1.6 percent of Burlington Northern’s currently outstanding common stock. Burlington Northern owns one of the largest railroad networks in North America, with 32,000 route miles covering 28 states and two Canadian provinces.
General. In recent years, we have followed a policy of maintaining a relatively liquid financial condition at the parent company in the form of cash, marketable securities, available credit lines and minimal amounts of debt. This policy has permitted
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2005, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows (in thousands):
Our insurance operating units have obligations to make certain payments for losses and LAE pursuant to insurance policies they issue. These future payments are reflected as reserves on our financial statements. With respect to loss and LAE, there is typically no minimum contractual commitment associated with insurance contracts and the timing and ultimate amount of actual claims related to these reserves is uncertain. Additional information regarding reserves for loss and LAE, including information regarding the timing of payments of these expenses, can be found on pages 13 through 16, page 22, pages 30 through 33 and pages 42 through 44 of this Form 10-K Report.
On May 3, 2004, AIHL acquired DNA for cash consideration of approximately $20.4 million, $17.1 million of which represented consideration for DNA’s investment portfolio and the balance of which represented consideration for licenses. On May 2, 2005, DNA acquired Darwin Select for cash consideration of approximately $25.3 million, $22.3 million of which represented consideration Darwin Select’s investment portfolio and the balance of which represented consideration for licenses.
Alleghany Properties. As part of our sale of Sacramento Savings Bank in 1994, we, through our wholly owned subsidiary Alleghany Properties, purchased the real estate and real estate-related assets of Sacramento Savings. Alleghany Properties is our only subsidiary holding substantial real estate investments. As of December 31, 2005, Alleghany Properties held properties having a total book value of approximately $27.5 million, as compared with approximately $30.1 million as of December 31, 2004 and approximately $32.7 million as of December 31, 2003. These properties and loans had a total book value of approximately $90.1 million as of October 31, 1994 (the date Alleghany Properties purchased the assets). The capital needs of Alleghany Properties consist primarily of various development costs relating to its owned properties and corporate administration. Adequate funds to provide for the currently foreseeable needs of its business are expected to be generated by sales and, if needed, capital contributions by us. Alleghany Properties paid an aggregate of $10.0 million of cash dividends to us in 2003.
Alleghany Corporation, a Delaware corporation (“Alleghany,” or together with its subsidiaries, the “Company”), owns Alleghany Funding Corporation (“Alleghany Funding”); Alleghany Properties Holdings LLC and Alleghany Insurance Holdings LLC (“AIHL”). Alleghany owns 100 percent of these subsidiaries. Alleghany also owned Heads & Threads International LLC (“Heads & Threads”) until December 31, 2004 and World Minerals, Inc. (“World Minerals”) until July 14, 2005. Accordingly, the operations of Heads & Threads and World Minerals have been reclassified as discontinued operations for all periods presented. See Note 2.
The accompanying consolidated financial statements include the results of Alleghany and its majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company balances and transactions have been eliminated in consolidation.
Investments consist of equity securities, debt securities, short-term investments and other invested assets. The Company classifies its marketable equity securities, debt securities and short-term investments as available for sale. Debt securities consist of securities with an initial maturity of more than one year. Such securities primarily include U.S. Treasury, Federal National Mortgage and Federal Home Loan Mortgage notes. Short-term investments include commercial paper, certificates of deposit, money market instruments and any fixed maturity with an initial maturity of one year or less. The Company has investments in two partnerships totaling $10.9 million which are included in other invested assets and are accounted for using the equity method of accounting.
At December 31, 2005 and 2004, available for sale securities are recorded at fair value based on quoted market prices or dealer quotes. Unrealized gains and losses during the year, net of the related tax effect applicable to available-for-sale securities, are excluded from earnings and reflected in comprehensive income and the cumulative effect is reported as a separate component of common stockholders’ equity until realized. A decline in the fair value of an available-for-sale security below its cost that is deemed other-than-temporary is charged to earnings.
Realized gains and losses on investments are determined on the specific identification method.
The Company has only limited involvement with derivative financial instruments and does not use them for trading purposes. The Company enters into interest rate swaps for purposes of converting variable interest rate exposure to a fixed rate and to match interest expense with interest income. Interest rate swaps are accounted for as a hedge of the obligation. Interest expense is recorded using the revised interest rate.
Premiums are recognized as revenue on a pro-rata basis over the term of an insurance policy. This recognition is based on the short term (twelve months or less) nature of the lines of business written by AIHL’s insurance operating units, which consist of property and casualty and surety and fidelity lines. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of insurance policies in force.
AIHL follows the customary practice of reinsuring with other companies a portion of the loss exposures on business its insurance operating units have written. This practice allows AIHL’s insurance operating units to diversify their business and write larger policies, while limiting the extent of their primary maximum net loss. Reinsuring loss exposures does not relieve AIHL’s insurance operating units from their obligations to policyholders. AIHL’s insurance operating units remain liable to their policyholders for the portion reinsured to the extent that any reinsurer does not meet the obligations assumed under the reinsurance agreements. To minimize their exposure to losses from a reinsurer’s inability to pay, AIHL’s insurance operating units periodically evaluate the financial condition of their reinsurers.
Acquisition costs related to unearned premiums that vary with, and are directly related to, the production of such premiums (principally commissions, premium taxes, compensation and certain underwriting expenses) are deferred. Deferred acquisition costs are amortized to expense as the related premiums are earned. Deferred acquisition costs are periodically reviewed to determine their recoverability from future income, including investment income, and if any such costs are determined to be not recoverable they are charged to expense. Deferred acquisition costs amortized to expense in 2005 and 2004 were $83.8 and $62.2 million, respectively.
Depreciation of buildings and equipment and amortization of leasehold improvements are principally calculated using the straight-line method over the estimated useful life of the respective assets or the life of the lease, whichever is less. Rental expense on operating leases is generally recorded on a straight-line basis over the term of the lease, regardless of the timing of actual lease payments.
Goodwill and certain intangible assets are deemed to have an indefinite useful life are subject to an annual review for impairment. Other intangible assets that are not deemed to have an indefinite useful life will continue to be amortized over their useful lives.
The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Revenue and profits from land sales are recognized using the full accrual method when title has passed to the buyer, the collectibility of the sales price is reasonably assured, the required minimum cash down payment has been received and the Company has no continuing involvement with the property. The Company has recorded sales under the full accrual method as all requirements have been met.
Net earnings per share of common stock are based on the average number of shares of Alleghany common stock outstanding during the years ended December 31, 2005, 2004 and 2003, respectively, as adjusted for stock dividends. The average number of shares of common stock outstanding, as adjusted for stock dividends, was 7,886,012 in 2005, 7,821,167 in 2004 and 7,751,630 in 2003.
The compensation cost that has been charged against income for Alleghany’s stock-based plans was $16.7 million, $16.7 million and $7.7 million in 2005, 2004 and 2003, respectively. Had compensation cost for Alleghany’s two stock-based compensation plans been determined based on the fair value at the grant date for awards under those plans consistent with the method of SFAS 123, Alleghany’s net earnings and earnings per share would have changed to the pro forma amounts indicated as follows (in thousands except for per share amounts):
Effective December 31, 2003, the Company adopted Emerging Issues Task Force (“EITF”) Issue 03-01 (EITF 03-01), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 requires that certain quantitative and qualitative disclosures be made for debt and marketable equity securities classified as available for sale that are impaired at the balance sheet date, but for which an other-than-temporary impairment has not been recognized. The Company has added the applicable disclosure information in Note 3. In November 2005, FASB Staff Position FAS 115-1 was issued and is effective for reporting periods beginning after December 15, 2005. The Company will adopt the guidance in this Staff Position in the first quarter of 2006 and does not anticipate that it will have any effect on the carrying value of its portfolio of securities.
On December 31, 2004, Alleghany merged its wholly-owned subsidiary, Heads & Threads, with and into HTI Acquisition LLC, an acquisition vehicle formed by a private investor group led by Heads & Threads management and Capital Partners, Inc. Alleghany received consideration of approximately $54 million in cash, subject to adjustment based on net book value at closing. The transaction generated a pre-tax loss of $1.95 million and an after-tax loss of $1.2 million, and such amounts were included in the Company’s 2004 financial statements as discontinued operations.
In 2005, upon final settlement of closing adjustments with the private investor group, Alleghany wrote off a receivable in the amount of $1.2 million pre-tax and $0.8 million after-tax during the 2005 second quarter. During the 2005 fourth quarter, Alleghany recorded a charge of $0.4 million pre-tax and $0.2 million after-tax relating to pension and other liabilities. Such amounts are included in discontinued operations for 2005.
The results of operations for each of the two years ending in 2004 are shown below (in thousands):
Alleghany paid legal, accounting and investment banking fees of $4.9 million in connection with the transaction. The sale of World Minerals produced an after-tax gain of $18.6 million in 2005. Alleghany has classified the operations of World Minerals as a “discontinued operation” in its financial statements for all periods presented. Historical balance sheet information* relating to World Minerals is set forth in the following table (in thousands):
Available for sale securities at December 31, 2005 and 2004 are summarized as follows (in thousands):
The amortized cost and estimated fair value of debt securities at December 31, 2005 by contractual maturity are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Excluded from the table above is other income of $12,017 thousand, $11,204 thousand and $19,061 thousand for 2005, 2004 and 2003, respectively. Other income is comprised principally of real estate income.
The Company reviews the available-for-sale securities that are trading below cost each quarter. If the review indicates that the declines were other-than-temporary, a realized capital loss will be recorded. There was a realized capital loss recorded in 2005 of $40 thousand. Realized capital losses of $0.3 million and $0.4 million were recorded in 2004 and 2003, respectively.
At December 31, 2005, approximately 1.9 percent of the carrying value of the Company’s debt securities portfolio was below investment grade or not rated. At December 31, 2005, non-income producing invested assets were insignificant.
At December 31, 2005 and 2004, investments carried at fair value totaling $53.3 million and $44.2 million, respectively, were on deposit with various states or governmental agencies to comply with property and casualty insurance regulations.
At December 31, 2005, AIHL had reinsurance recoverables of $1.5 billion on gross unpaid loss and loss adjustment expenses of $2.6 billion. AIHL’s largest concentration of reinsurance recoverables at December 31, 2005 was $164.4 million due from Employers Re, representing 10 percent of total reinsurance recoverables and $162.3 million due from Lloyds of London, representing 9.9 percent of total reinsurance recoverables. At December 31, 2005, the A.M. Best Company, Inc. (“A.M. Best”) financial strength ratings of Employers Re and Lloyds of London was A (Excellent). Approximately 97.2 percent of AIHL’s reinsurance recoverables at December 31, 2005 was with reinsurers having an A.M. Best financial strength rating of A (Excellent) or higher. AIHL had no allowance for uncollectible reinsurance as of December 31, 2005. In connection with the acquisitions of Platte River Insurance Company (“Platte River”) and Landmark (discussed in more detail below), the sellers contractually retained all of the loss and loss adjustment expense liabilities. These contractual provisions constituted loss reserve guarantees as contemplated under EITF D-54, “Accounting by the Purchasers for a Seller’s Guaranty of the Adequacy of Liabilities for Losses and Loss Adjustment Expenses of an Insurance Enterprise Acquired in a Purchase Business Combination.” On January 3, 2002, Alleghany acquired Platte River from Swiss Reinsurance American Corporation (“Swiss Re”) pursuant to a Stock Purchase Agreement dated as of December 5, 2001, and transferred Platte River to AIHL pursuant to a Contribution Agreement dated January 3, 2002. The Stock Purchase Agreement provides that Swiss Re shall indemnify and hold harmless Alleghany, AIHL and Platte River and their respective directors, officers and employees from and against any and all liabilities arising out
On September 2, 2003, RIC acquired Landmark from Guaranty National pursuant to a Stock Purchase Agreement dated as of June 6, 2003. In contemplation of the sale of Landmark to RIC, Landmark and Royal Indemnity Company, an affiliate of Guaranty National (“Royal Indemnity”), entered into a 100 percent Quota Share Reinsurance Agreement and an Assumption of Liabilities Agreement, each dated as of September 2, 2003. Pursuant to these two agreements, Royal Indemnity assumed all of Landmark’s liabilities of any nature arising out of or relating to all policies, binders and contracts of insurance issued in Landmark’s name prior to the closing under the Stock Purchase Agreement, and all other liabilities of Landmark. The reinsurance recoverable and loss reserve liability recorded was $37.3 million at December 31, 2003 and decreased to $23.7 million at December 31, 2004 and to $14.5 million at December 31, 2005.
The following table indicates property and casualty premiums written and earned for the years ended December 31, 2005, 2004 and 2003 (in thousands):
The 2003 premiums attributable to reinsurance assumed are due to arrangements established in connection with two acquisitions made by AIHL where the sellers issued policies at the request of the acquired company and the acquired company reinsured the risk of the seller under those policies net of certain reinsurance.
Written premiums assumed were $375.8 million in 2003. Of this amount, about $374.7 million arose in connection with AIHL’s acquisition on July 1, 2003 of Resurgens Specialty, which became a subsidiary of RSUI, and on June 30, 2003, RSUI acquired RIC to issue the insurance policies underwritten by Resurgens Specialty. At the time of its acquisition by RSUI, RIC was licensed in several states but was not licensed in all states in which Resurgens Specialty operated, and it was anticipated that it would take several months for RIC to obtain licenses in all such states. Consequently, and in connection with the acquisition of Resurgens Specialty, RSA agreed to provide policy-issuing services to RIC through June 2004 to cover this regulatory transition period. Thus, in a typical transaction in a state in which RIC was not yet licensed, Resurgens Specialty, as the underwriting agency, would underwrite the coverage, and one of R&SA’s carriers would issue the policy to the insured. RIC then assumed the obligations of the R&SA carrier under the policy. RIC ceased using this R&SA policy issuing arrangement in the fourth quarter of 2003.
CATA uses reinsurance to protect against severity losses. In 2005, CATA reinsured individual property and casualty and contract surety risks in excess of $1.5 million with various reinsurers. The commercial surety line was reinsured for individual losses above $1.25 million. In addition, CATA purchases facultative reinsurance coverage for risks in excess of $6.0 million on property and casualty and $10.0 million on commercial surety.
Total gross and net loss and loss adjustment expense reserves increased at December 31, 2005 from December 31, 2004 by $1,348.7 million primarily reflecting an increase in both property and casualty loss and loss adjustment expense reserves. Property lines of business increased $909.1 million primarily reflecting losses at RSUI due to 2005 hurricane activity. Casualty lines of business increased $460.0 million primarily reflecting increased earned premium in D&O liability and professional liability and limited paid loss activity for the current and prior casualty accident years. Gross loss and loss adjustment expense reserves include loss reserves acquired in connection with the acquisition of Platte River due to the settlement in 2005 of some of these acquired reserves by the seller of Platte River, gross loss and loss adjustment expense reserves declined by $22.2 million. Since these acquired loss reserves are ceded 100 percent to the seller of Platte River, they are not reflected in net loss and loss adjustment expense reserves. Information regarding such acquired reserves is contained in Note 5.
Total debt at December 31, 2005 and 2004 is summarized as follows (in thousands):
Alleghany Funding’s notes of $80 million are secured by a $91.5 million installment note receivable (see Note 4). Alleghany Funding has entered into a related interest rate swap agreement with a notional amount of $86.2 million for the purpose of matching interest expense with interest income. This swap is pay variable, receive variable. Alleghany Funding pays a variable rate equal to the one-month commercial paper rate plus 0.0625 percent and receives a variable rate equal to the three-month LIBOR rate plus 0.375 percent. The swap matures on January 22, 2007. Alleghany Funding is exposed to credit risk in the unlikely event of nonperformance by the swap counter-party. Alleghany monitors the credit rating of the swap counter-party.
A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. In the opinion of the Company’s management, realization of the recognized net deferred tax asset of $117,524 thousand is more likely than not based on expectations as to the Company’s future taxable income.
The total number of shares of all classes of capital stock that Alleghany has authority to issue is 30,000,000, of which 8,000,000 shares are preferred stock, par value of $1.00, and 22,000,000 shares are common stock, par value of $1.00.
Alleghany provides, through its 1993 Long-Term Incentive Plan (under which awards were granted through 2001 year-end) and its 2002 Long-Term Incentive Plan, incentive compensation of the types commonly known as restricted stock, stock options, stock appreciation rights, performance shares, performance units and phantom stock, as well as other types of incentive compensation. Awards may include, but are not limited to, cash and/or shares of Alleghany’s common stock, rights to receive cash and/or shares of common stock and options to purchase shares of common stock including options intended to qualify as incentive stock options under the Internal Revenue Code and options not intended to so qualify. The number of performance shares awarded under the incentive plans to current employees of the Company was 15,248, 29,574 and 31,382 for the four-year award periods beginning in 2005, 2004 and 2003, respectively (as adjusted for stock dividends).
Alleghany also provides, through its Amended and Restated Directors’ Stock Option Plan (under which options were granted through May 1999) and its 2000 Directors’ Stock Option Plan (which terminated on December 31, 2004), for the automatic grant of non-qualified stock options to purchase 1,000 shares of common stock in each year after 1987 to each non-employee director. The 2005 Directors’ Plan provides for the automatic grant of non-qualified options to purchase 500 shares of common stock and 250 shares of restricted common stock. Options to purchase 3,500 shares and 1,750 shares of restricted stock at the then fair market value of $273.32 were granted in 2005. At December 31, 2005, 80,129 options were outstanding, of which 69,441 options were vested at an average option price of $158.34.
No options were granted to subsidiary directors in 2005. At December 31, 2005, 7,907 options issued to subsidiary directors were outstanding and fully vested at an average option price of $185.57.
A summary of the status of the Company’s fixed option plans as of December 31, 2005, 2004 and 2003 and changes during the years ending on those dates is presented as follows:
The following tables set forth the defined benefit plans’ funded status at December 31, 2005 and 2004 and total cost for each of the three years ended December 31, 2005 (in millions, except percentages):
Contributions of $0.3 million are expected to be made to Alleghany’s funded employee plan during 2006.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be made (in thousands):
Comprehensive income requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately in the equity section of the balance sheet. Accumulated other comprehensive income of the Company consists of unrealized gains on investment securities, foreign exchange translation adjustments and minimum pension liability (in thousands):
The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2005 were as follows (in millions):
The Products Liability Indemnification is divided into two parts, the first relating to products liability claims arising in respect of events occurring during the period prior to Alleghany’s acquisition of the World Minerals business from Johns Manville Corporation, Inc. (f/k/a Manville Sales Corporation) (“Manville”) in July 1991 (the “Manville Period”) and the second relating to products liability claims arising in respect of events occurring during the period of Company ownership (the “Alleghany Period”). Under the terms of the Stock Purchase Agreement, Alleghany will provide indemnification at a rate of 100 percent for the first $100.0 million of losses arising from products liability claims relating to the Manville Period and at a rate of 50 percent for the next $100.0 million of such losses, so that Alleghany’s maximum indemnification obligation in respect of products liability claims relating to the Manville Period is $150.0 million. This indemnification obligation in respect of Manville Period products liability claims will expire on July 31, 2016. The Stock Purchase Agreement states that it is the intention of the parties that, with regard to losses incurred in respect of products liability claims relating to the Manville Period, recovery should first be sought from Manville, and that Alleghany’s indemnification obligation in respect of products liability claims relating to the Manville Period is intended to indemnify the Purchaser for such losses which are not recovered from Manville within a reasonable period of time after recovery is sought from Manville. In connection with World Minerals’ acquisition of the assets of the industrial minerals business of Manville in 1991, Manville agreed to indemnify World Minerals for certain product liability claims, in respect of products of the industrial minerals business manufactured during the Manville Period, asserted against World Minerals through July 31, 2006. World Minerals did not assume in the acquisition liability for product liability claims to the extent that such claims relate, in whole or in part, to the Manville Period, and Manville should continue to be responsible for such claims, notwithstanding the expiration of the Manville indemnity in 2006.
For products liability claims relating to the Alleghany Period, Alleghany will provide indemnification for up to $30.0 million in the aggregate. The $10.0 million holdback from the Adjusted Purchase Price paid at the closing secures performance of this indemnification obligation relating to the Alleghany Period, and, unless and until the holdback amount is exhausted, will be charged for any claim for payment in respect of this indemnification obligation that would otherwise be made to Alleghany. In addition to the indemnification obligation undertaken by Alleghany in respect of products liability claims relating to the Alleghany Period, the Stock Purchase Agreement provides that, after the closing, Alleghany will continue to make available to World Minerals $30.0 million per policy period of Alleghany’s umbrella insurance coverage in effect on a Company group-wide basis for policy periods beginning on April 1, 1996 (prior to April 1, 1996, World Minerals had its own umbrella insurance coverage). This portion of Alleghany’s umbrella insurance coverage will be available to World Minerals for general liability claims as well as for products liability claims. The Stock Purchase Agreement states that it is the intention of the parties that, with regard to losses incurred in respect of products liability claims relating to the Alleghany Period, recovery should first be sought under any available World Minerals insurance policies and second under the portion of Alleghany’s umbrella insurance coverage made available to World Minerals after the closing, and that Alleghany’s indemnification obligation in respect of products liability claims relating to the Alleghany Period is intended to indemnify the Purchaser for such losses in respect of which coverage is not available under either the World Minerals insurance policies or under such portion of Alleghany’s umbrella insurance coverage. Alleghany’s indemnification obligation in respect of Alleghany Period products liability claims will expire on July 14, 2015, which is the tenth anniversary of the closing date.
Premium balances receivable and reinsurance payable: The carrying amount approximates fair value.
Selected quarterly financial data for 2005 and 2004 presented below (in thousands, except per share amounts):
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Alleghany Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, changes in common stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated February 27, 2006 expressed an unqualified opinion on those consolidated financial statements.