(b) The results of operations reflect those of Argonaut Group for the year ended December 31, 2007 and those of PXRE from the point of acquisition, August 7, 2007 to December 31, 2007.
For the year ended December 31, 2009, Argo Group reported net income of $117.5 million, or $3.81 per fully diluted share. For the year ended December 31, 2008, Argo Group reported net income of $62.9 million, or $2.05 per fully diluted share. In May 2008, the Company completed the acquisition of Argo International. Included in the Company’s consolidated results of operations for the year ended December 31, 2008, is seven months of activity specifically attributable to Argo International. Net income for the year ended December 31, 2007 was $143.8 million, or $5.58 per fully diluted share, including an extraordinary gain resulting from the Merger of PXRE and Argonaut Group of $66.3 million, or $2.57 per fully diluted share. The following is a comparison of selected data from the Company’s operations:
Consolidated net investment income decreased for the year ended December 31, 2009 as compared to the same period in 2008 due to lower investment yields which were partially offset by higher total invested assets resulting from positive operating cash flows. Consolidated net investment income increased for the year ended December 31, 2008 as compared to the same period in 2007 due to higher invested asset balances due to positive cash flows from operations coupled with invested assets acquired in the acquisition of Argo International. Total invested assets at December 31, 2009 were $4,099.0 million, net of $235.3 million of invested assets attributable to Argo International’s Trade Capital providers. Total invested assets at December 31, 2008 were $3,779.6 million, net of $215.8 million of invested assets attributable to the Trade Capital providers. Total invested assets as of December 31, 2007 were $3,582.8 million.
Included in consolidated losses and losses adjustment expenses for the year ended December 31, 2008 was $72.3 million in losses resulting from hurricane activity in the United States during the third quarter of 2008. Losses and loss adjustment expenses for 2008 also include $22.5 million in property losses resulting primarily from severe weather during the second quarter of 2008 and $18.9 million of losses in certain casualty lines of business resulting from higher than expected severity in the fourth quarter of 2008. Prior accident year net favorable loss reserve development recognized during 2008 was $61.2 million of which $31.8 million related to property lines of business. This favorable development included $14.3 million from the 2006 and 2007 accident years within the U.S. operations, $12.5 million from the PXRE non-catastrophe lines and $5.0 million from 2005 PXRE catastrophe reserves. Net favorable development across casualty lines of business totaled $29.4 million and resulted from $27.5 million of favorable development in general and other liability lines of business primarily related to accident years 2005 and prior, $13.8 million of net favorable development within workers compensation and commercial multi peril lines primarily related to accident years 2006 and prior, adverse development of $6.8 million in commercial auto liability lines for 2006 and 2007 accident years and net adverse development of $5.2 million for asbestos and environmental reserves.
The net favorable loss and loss adjustment expense development for the twelve months ended December 31, 2009 was approximately 0.3% of total reserves outstanding as of December 31, 2008. The reinsurance - nonproportional assumed property favorable net loss reserve development was driven by $10.8 million of favorable development in the PXRE Legacy reserves (including $3.2 million for the 2005 hurricanes) and $8.0 million of favorable development in Argo Re (including $3.1 million related to hurricane Ike in 2008). The general liability line of business had $9.2 million of favorable prior accident year development primarily driven by favorable Excess and Surplus Lines development, partially offset by the unfavorable reserve development for certain asbestos and environmental claims in the Run-Off Lines segment. The favorable development in the workers compensation and auto physical damage lines of business resulted from better than expected loss frequency and severity. The Argo International net loss reserves developed unfavorably by $23.5 million as described above. The unfavorable reserve development for commercial auto liability was primarily attributable to increased frequency and severity.
Consolidated interest expense and other were $25.5 million, $31.0 million and $24.4 million for the years ended December 31, 2009, 2008 and 2007, respectively. Consolidated interest expense decreased to $25.7 million for the year ended December 31, 2009 compared to $29.9 million and $20.9 million for the same periods in 2008 and 2007, respectively. The decrease in interest expense for the year ended December 31, 2009 as compared to 2008 was due to reduced interest rates and the repayment of outstanding balances on the Company’s revolving line of credit during the year. The increase in interest expense for the year ended December 31, 2008 as compared to 2007 was due to the inclusion of a full year of interest on the junior subordinated debentures acquired in the Merger with PXRE, coupled with $1.1 million in interest expense related to Argo International indebtedness assumed in May 2008. Also included in consolidated interest expense and other for the year ended December 31, 2008 was $0.6 million resulting from the net change in fair value on derivative reinsurance contracts, compared to $3.5 million for 2007.
In June 2009, the Company deemed the value assigned to the trade name of Heritage impaired after an evaluation of the value of the name in the Lloyd’s market and the subsequent renaming of Heritage to Argo International. The expense recognized as a result of this impairment was $5.9 million, which represented the unamortized balance as of the impairment date.
Consolidated provisions for income taxes were $24.9 million, $23.5 million and $42.3 million for the years ended December 31, 2009, 2008 and 2007, respectively. Included in the consolidated provision for income taxes for the year ended December 31, 2009 was a $5.6 million tax refund received from the state of California due to a favorable tax settlement. Offsetting this tax refund was $7.7 million in tax expense from Argo Financial Holding (Ireland) Ltd to the Internal Revenue Service for withholding on dividends received from Argo Group US. The consolidated income tax provision represents the income tax expense associated with the Company’s operations based on the tax laws of the jurisdictions in which they operate. Therefore, the consolidated provision for income taxes represents taxes on net income for the Company’s United States and United Kingdom operations. Additionally, the Company’s tax rate for 2009 and 2008 were impacted by fluctuations in foreign exchange rates within the International Specialty segment.
Since the Company generally manages and monitors the investment portfolio on an aggregate basis, the overall performance of the investment portfolio, and related net investment income, is discussed above on a combined basis under consolidated net investment income rather than within or by segment.
The decline in gross written premiums was primarily due to market conditions. The excess and surplus lines market place continues to experience increased competition, from both other excess and surplus lines carriers as well as the standard markets, which has led to lower rates and business shifting to the standard markets. Pricing in the Excess and Surplus Lines segment has declined moderately for the year ended December 31, 2009 as compared to the same periods in 2008 and 2007. Additionally, the Excess and Surplus Lines segment has experienced a shift in both product and policyholder mix, resulting in reduced premium writings.
The increase in earned premiums for the year ended December 31, 2009 as compared to the same period in 2008 was primarily attributable to the termination of a ceded quota share reinsurance contract in April 2008. Premiums ceded under this contract reduced earned premiums $51.3 million for the year ended December 31, 2008. The decline in earned premium for the year ended December 31, 2008 as compared to the same period in 2007 was primarily attributable to a decline in gross written premiums in 2008. Additionally, earned premiums for the year ended December 31, 2008 were reduced by $4.0 million of reinstatement premiums related to property catastrophe reinsurance contracts resulting from Hurricanes Gustav and Ike. Partially offsetting earned premiums for the year ended December 31, 2007 was a $4.1 million increase in ceded premiums under a property reinsurance contract due to a shortfall in the minimum subject premium under this contract.
Loss reserves for the Excess and Surplus Lines segment were $1,359.6 million, $1,257.7 million and $1,084.7 million at December 31, 2009, 2008 and 2007, respectively.
The following table summarizes the results of operations for the Commercial Specialty segment:
Losses and loss adjustment expenses for the year ended December 31, 2009 resulted in a loss ratio of 65.9%, compared to 68.0% and 60.3% for the same periods ended 2008 and 2007, respectively. The decrease in the loss ratio in 2009 compared to 2008 was primarily attributable to the absence of hurricane activity, $2.0 million lower storm related activity and $9.5 million decrease in non-catastrophe property and casualty lines losses. Additionally, the Commercial Specialty segment recognized $3.7 million of favorable development on prior accident years loss reserves in 2009. This favorable development was comprised primarily of $6.2 million of favorable development in workers compensation, $3.5 million of favorable development in short tail lines, $2.5 million of adverse development in other liability, and $3.5 million of adverse development in commercial auto liability.
Loss reserves for the Commercial Specialty segment were $605.4 million, $574.8 million and $481.7 million as of December 31, 2009, 2008 and 2007, respectively.
The expense ratio for the year ended December 31, 2009 and 2008 was at 29.7% and 28.5%, respectively. The increase in the expense ratio was primarily attributable to reduced ceding commissions received on the state fund program due to lower premium volumes, along with a business shift to large deductible products from guaranteed cost products in the coal mining business. The expense ratio for the year ended December 31, 2008 and 2007 were comparable at 28.5% and 28.4%, respectively.
Earned premiums for the year ended December 31, 2009 increased as compared to the same period in 2008 as a result of an improved property catastrophe rate environment, a greater use of outward reinsurance and third party quota shares, and the introduction of a primary excess casualty and professional lines unit. Earned premiums for property catastrophe lines increased to $71.3 million for the year ended December 31, 2009 compared to $52.4 million for the same period in 2008. The casualty and professional lines unit contributed earned premiums of $4.1 million for the year ended December 31, 2009. Earned premiums for other assumed programs were $12.3 million and $17.5 million, respectively, for the years ended December 31, 2009 and 2008. The increase in earned premiums for the year ended December 31, 2008 as compared to 2007 was primarily attributable to the effect of initiating operations for Argo Re in 2008. Earned premiums for the assumed programs were comparable for the years ended December 31, 2008 and 2007, respectively, as the Company’s assumed programs remained relatively unchanged.
Losses and loss adjustment expenses for the year ended December 31, 2009 resulted in a loss ratio of 17.5%, compared to 47.1% and 54.4% for the same periods ended 2008 and 2007, respectively. Losses and loss adjustment expenses for the year ended December 31, 2009 reflect no major loss events for the 2009 accident year. Losses and loss adjustment expenses for the year ended December 31, 2009 included $3.6 million in favorable loss reserve development for the 2008 accident year due to Hurricane Ike losses developing more favorably than original estimates, coupled with $4.4 million of favorable reported loss activity on the non-catastrophe losses. Included in losses and loss adjustment expense for the year ended December 31, 2008 were $16.1 million in losses resulting from the hurricanes Gustav and Ike, including $9.6 million attributable to Argo Re’s property catastrophe programs. The Reinsurance segment had favorable loss development in 2008 of $2.7 million driven by favorable property loss reserve development on two reinsurance contracts. Absent the hurricane activity, the loss ratio for the year ended December 31, 2008 as compared to 2007 declined due to the inclusion of a full year of Argo Re results, which underwrites to a lower ultimate loss ratio than the assumed business.
The increase in the expense ratio for the year ended December 31, 2009 as compared to 2008 was primarily attributable to increased staffing and related costs associated with starting the new casualty and professional lines units. Expenses associated with these units, as is typical for a start up operation, are disproportionately higher than the rate at which premiums are earned. The decrease in the expense ratio for the year ended December 31, 2008 as compared to 2007 was the result of the overall increase in earned premiums.
Subsequent to the acquisition and in preparation for the 2009 year of account, Argo Underwriting Agency increased its participation to 61% from 54% for the prior year of account for Syndicate 1200 results, and is maintaining that participation for the 2010 year of account. For the 2008 year of account, Argo Underwriting Agency increased its participation in Syndicate 1200 to 54% compared to 48% for the 2007 year of account. Argo Managing Agency manages syndicate 1200 and also managed Syndicate 3245 for the 2007 and prior years of account. Argo Underwriting Agency participated in 28% of Syndicate 3245 for the 2007 year of account and increased its participation to 54% upon Syndicate 3245 merging into Syndicate 1200 for the 2008 year of account. For Syndicate 1200 results not retained by the Company, Argo Managing Agency receives fee income for underwriting services provided to third party capital providers. Lloyd’s stamp capacity for Syndicate 1200 for the 2008 and 2009 years of account was £325 million. For the 2010 year of account, Lloyd’s stamp capacity has been increased to £350 million.
The increase in the expense ratio for the year ended December 31, 2009 as compared to the period ended December 31, 2008 was primarily the result of a different mix of business. The change in business mix resulted in higher commission program business and less open market property business in particular the binder premium relating to prior exposures. Additionally, included in expenses for 2009 were post-acquisition costs associated with integrating the International Specialty segment into the business.
Fee income, net represents fees and profit commission derived from the Company’s management of third party capital for the underwriting syndicates at Lloyd’s, net of associated expenses. Fee income, net of $0.7 million for the year ended December 31, 2009 was less than the $6.6 million fee income for the last seven months of 2008 due to reduction in profit estimates particularly 2008 year of account. In addition, the Company’s trade name was changed from Heritage to Argo during 2009. As a result, the remaining unamortized intangible of $5.9 million associated with the Heritage trade name was written off.
The following table summarizes the results of operations for the Run-off Lines segment:
Underwriting expenses for the year ended December 31, 2009 decreased as compared to 2008 and 2007 due to reduced administrative expenses. Bad debt expense on uncollectible reinsurance recoverable balances of $4.8 million and $5.8 million were included for the years ended December 31, 2009 and 2008, respectively.
Argonaut Insurance Company also assumed risk as a reinsurer, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance Company also reinsured risks on policies written by domestic carriers. Such reinsurance typically provided coverage for limits attaching at a relatively high level which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance Company are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no apparent medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that a significant portion of claims generated out of this population of claimants may result in incurred losses generally lower than the asbestos claims filed over the past decade and could be below the attachment level of Argonaut Insurance Company.
The Company performs an extensive actuarial analysis of the asbestos and environmental reserves on at least an annual basis. The process is typically completed in the third quarter of the calendar year and reviewed/updated during the fourth quarter. The Company continually monitors the status of the claims, and may make adjustments outside of the annual review period. The review entails a detailed analysis of the Company’s direct and assumed exposure. The Company utilizes a consulting actuary to assist in determining the indicated liability and then reviews the study results. Management considers that estimate in determining their best estimate of the asbestos and environmental loss and loss adjustment expense reserves.
The number of claims opened during the three years ended December 31, 2009 were as follows:
Settlement of litigation in the second quarter of 2009 pertaining to a single asbestos case accounted for 138 of the 157 direct claims that were established in 2009. New claims in the reinsurance assumed categories are primarily the result of the Company typically providing coverage for higher limits which are payable only after other layers of reinsurance are exhausted. Additionally, there tend to be long delays in the ceding companies reporting claims to the reinsurers.
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2009:
Because of the types of coverages within the Run-off Lines of business still being serviced by Argonaut Insurance Company, a significant amount of subjectivity and uncertainty exists in establishing the reserves for losses and loss adjustment expenses. Factors that increase these uncertainties are: (1) lack of historical data, (2) inapplicability of standard actuarial projection techniques, (3) uncertainties regarding ultimate claim costs, (4) coverage interpretations, and (5) the judicial, statutory and regulatory environments under which these claims may ultimately be resolved. Significant uncertainty remains as to the ultimate liability to the Company due to the potentially long waiting period between exposure and emergence of any bodily injury or property damage and the resulting potential for involvement of multiple policy periods for individual claims. Due to these uncertainties, the current trends may not be indicative of future results. Although management has determined and recorded its best estimate of the reserves for losses and loss adjustment expenses for Run-off Lines, current judicial and legislative decisions continue to broaden liability, expand policy scopes and increase the severity of claims payments. As a result of these and other recent developments, the uncertainties inherent in estimating ultimate loss reserves are heightened, further complicating the already complex process of determining loss reserves. The industry as a whole is involved in extensive litigation over these coverages and liability issues, and must contend with the continuing uncertainty in its effort to quantify these exposures.
Cash provided by operating activities can fluctuate due to timing difference in the collection of premiums and reinsurance recoverables and the payment of losses and expenses. For the year ended December 31, 2009, net cash provided by operating activities was $301.8 million, compared to $118.5 million and $166.2 million for the years ended December 31, 2008 and 2007, respectively. The increase in cash flows from operations in 2009 as compared to 2008 was primarily attributable to the inclusion of a full year of Argo International activity and increased cash flow from the U.S. and Bermuda operations. The decrease in cash flows from operations in 2008 as compared to 2007 was primarily attributable to Argo International’s positive net cash flow offset by increased claim payments for Argo Group US and Argo Re in 2008 as compared to these two entities’ claim payments in 2007.
Net cash used by investing activities totaled $240.8 million, $115.4 million and $189.3 million for the years ended December 31, 2009, 2008 and 2007, respectively. In 2009, cash was primarily used to acquire fixed maturity securities. The decrease in the amount of net cash used in 2008 as compared to 2007 was primarily due to the cash payments associated with the Company’s 2008 acquisitions (Argo International, Massamont, and Insight) being less than the net proceeds from investment activity year over year and the cash proceeds received in 2008 from the sale of PXRE Reinsurance Company. In 2007, cash was primarily used to acquire fixed maturity and equity securities, offset by cash received from sales, calls and maturities of fixed maturity securities and sales of equity securities. The Company received net cash of $10.4 million upon the closing of the Merger of PXRE and Argonaut Group in August 2007. As of December 31, 2009, 2008 and 2007, $439.3 million, $513.6 million and $648.8 million, respectively, of the investment portfolio were invested in short-term investments. The increase in 2008 and 2007 reflects the duration of liabilities from Argo Re.
For the year ended December 31, 2009 and 2008, net cash used by financing activities totaled $48.1 million and $11.6 million, respectively. For the years ended December 31, 2007, cash provided by financing activities totaled $15.5 million. The decrease in financing activities in 2009 is primarily resulting from the net cash payment on the revolving credit facility. The decrease in financing activities in 2008 is resulting from less activity from the Company’s stock incentive plans in 2008 due to the respective strike price of the awards being in excess of market price, net cash payment on the revolving credit facility and the repurchase by the Company of 145,999 shares of its common stock offset by no dividend payments made in 2008. The increase in cash provided by financing activities in 2007 as compared to 2006 was primarily the result of cash received from stock option exercises.
The Company and its other holding company subsidiaries are largely dependent on dividends and other permitted payments from its insurance and reinsurance subsidiaries to pay cash dividends to its shareholders, for debt service and for its operating expenses. The ability of the Company’s insurance and reinsurance subsidiaries to pay dividends to the Company is subject to certain restrictions imposed by the jurisdictions of domicile that regulate the Company’s immediate insurance and reinsurance subsidiaries and each jurisdiction has calculations for the amount of dividends that an insurance and reinsurance company can pay without the approval of the insurance regulator.
During 2010, Argonaut Insurance Company may be permitted to pay dividends of up to $56.8 million in cash without approval from the Illinois Department of Insurance, based on the state of domicile’s ordinary dividend calculation. Colony may be permitted to pay dividends of up to $36.8 million in cash without approval from the Virginia Bureau of Insurance, based on the state of domicile’s ordinary dividend calculation. Rockwood may be permitted to pay dividends of up to $15.6 million in cash without approval from the Pennsylvania Department of Insurance, based on the state of domicile’s ordinary dividend calculation. Business and regulatory considerations may impact the amount of dividends actually paid, and prior approval of dividend payments may be required.
The Company believes it has access to various sources of liquidity including cash, investments, and borrowings under its revolving credit facility as well as access to the debt and equity capital markets. On February 27, 2009 the Company entered into a $100 million, 364 day revolving credit facility with JPMorgan Chase Bank, N.A., as administrative agent, and other lenders thereto (the “Credit Agreement”). The Credit Agreement was amended to extend the maturity to April 30, 2010. The proceeds of borrowings can be used for general corporate purposes, including working capital and permitted acquisitions. At December 31, 2009, the Company had no borrowings outstanding under this agreement.
(2) Redeemable at a call prices of 104.18% at February 2007 declining to 100.418% at February 2016, and 100% thereafter
(3) Redeemable prior to September 2010, at the greater of a) 107.5% of principal plus accrued and unpaid interest or b) the sum of the discounted present value of the principal, the discounted present value of the interest payable during the fixed rate period remaining life and the accrued and unpaid interest. Redeemable after September 2010 at a price equal to 100% of the principal plus accrued and unpaid interest
The Company did not pay cash dividends in 2009 to its common shareholders. On February 19, 2010, the Company announced that the Board of Directors has reinstated a quarterly cash dividend in the amount of $0.12 on each share of common stock outstanding to be disbursed on March 15, 2010, to shareholders of record on March 1, 2010. The declaration and payment of dividends is at the discretion of the Board and will depend on the Company’s financial results, cash requirements, future prospects and other factors deemed relevant by the Board.
The Company invests excess cash in a variety of investment securities. As of December 31, 2009, the Company’s investment portfolio consisted of 81.5% fixed maturities, 6.2% equity securities, 2.2% other investments and 10.1% short-term investments (based on fair value) compared to 78.9% fixed maturities, 6.8% equity securities, 1.4% other investments and 12.9% short-term investments for the same period in 2008. The Company classifies the majority of its investment portfolio as available-for-sale; resulting in these investments being reported at fair market value, with unrealized gains and losses, net of tax, being reported as a component of shareholders’ equity. Of the Company’s total investments of $4,334.3 million, only $2.2 million is classified as trading. All trading investments are reported at fair market value, with unrealized gains and losses, net of tax, being reported as a component of net income. No issuer (excluding United States Government and United States Governmental agencies) of fixed income or equity securities represents more than 4.1% of shareholders’ equity at December 31, 2009.
The Company’s insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to fund operating expenses. During the three years ended December 31, 2009, the Company’s liquidity generated from operations and investment income were sufficient to meet obligations. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as satisfy its commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
The Company maintains a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard its financial position. The costs of the Company’s program, to the extent not passed on to customers through increased rates may have a negative impact on liquidity.
Credit risk is a major factor of the overall enterprise risk within the Company, and the Company has established policies and procedures to evaluate its exposure to credit risk, particularly with respect to its investment holdings and its receivable balances from insureds and reinsurers. The Company is also exposed to credit risk on losses recoverable from reinsurers and premiums receivable from insureds. Downturns in one sector or market can adversely impact other sectors and may result in higher credit exposure. The Company does not currently use credit default swaps to mitigate its credit exposure from either investments or counterparties.