(1) On August 30, 2013, we acquired a controlling equity interest in Kentucky Trailer; on April 26, 2012, we acquired BKI; and on March 6, 2012, we acquired TransRe.
The profitability of our reinsurance and insurance subsidiaries and, as a result, our profitability, is impacted primarily by the adequacy of premium rates, level of catastrophe losses and investment returns. The adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural disasters, regulatory measures and court decisions that expand the extent of coverage and grant larger liability awards, and the effects of economic inflation on the amount of compensation due for injuries or losses. The ultimate adequacy of premium rates is not known with certainty at the time reinsurance contracts are entered into or property and casualty insurance policies are issued because premiums are determined before claims are reported.
The profitability of our reinsurance and insurance subsidiaries is also impacted by competition generally and price competition in particular. Historically, the performance of the property and casualty reinsurance and insurance industries has tended to fluctuate in cyclical periods of price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. Although an individual reinsurance or insurance company’s performance is dependent on its own specific business characteristics, the profitability of most property and casualty reinsurance and insurance companies tends to follow this cyclical market pattern.
Catastrophe losses, or their absence, can have a significant impact on our results. The frequency and severity of catastrophes in any short period of time are inherently unpredictable. Catastrophes can cause losses in a variety of our property and casualty lines of business. We have significant exposure to both natural catastrophes, such as hurricanes, other windstorms and earthquakes, as well as man-made catastrophes. Longer-term natural catastrophe trends may be changing due to climate change, a phenomenon that has been associated with extreme weather events linked to rising temperatures, and includes effects on global weather patterns, greenhouse gases, sea, land and air temperatures, sea levels, rain and snow. Climate change, to the extent it produces rising temperatures and changes in weather patterns, could impact the frequency and severity of weather events such as hurricanes, other windstorms and tornado activity. To the extent climate change increases the frequency and severity of such weather events, our reinsurance and insurance subsidiaries may face increased claims, particularly with respect to properties located in coastal areas.
In 2013, we incurred $150.9 million of catastrophe losses, net of reinsurance, compared with $470.1 million in 2012 and $74.3 million in 2011. The catastrophe losses consisted of $92.1 million incurred at TransRe and $58.8 million incurred at RSUI for 2013; $278.4 million incurred at TransRe and $191.7 million incurred at RSUI for 2012; and $74.3 million incurred at RSUI for 2011. Catastrophe losses in 2012 included $433.4 million of losses incurred by TransRe and RSUI related to Super Storm Sandy, which also resulted in assumed (net of ceded) reinstatement premiums of $21.4 million, for a total pre-tax earnings impact of $412.0 million. In addition, we had prior accident year development on reserves related to catastrophe events that occurred in prior periods. Catastrophe losses and prior accident year development are explained in the following pages.
rating agencies and others who use financial information in evaluating the performance of Alleghany. This presentation includes the use of underwriting profit, which is a “non-GAAP financial measure,” as such term is defined in Item 10(e) of Regulation S-K promulgated by the SEC. 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, net realized capital gains, other than temporary impairment, or “OTTI,” losses, other income, other operating expenses, amortization of intangible assets or interest expense. We consistently use underwriting profit as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of our segments and believe that underwriting profit provides useful additional information to investors because it highlights net earnings attributable to a segment’s 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. However, underwriting profit is not meant to be considered in isolation or as a substitute for earnings before income taxes or any other measures of operating performance prepared in accordance with GAAP. A reconciliation of underwriting profit to earnings before income taxes is presented within “Consolidated Results of Operations.”
* Consists of Alleghany Properties, Stranded Oil, our investments in Homesite (prior to its sale on December 31, 2013) and ORX and corporate activities at the parent level, including the gain on bargain purchase in
Our earnings before income taxes in 2012 increased from 2011, primarily reflecting merger impacts in 2012, partially offset by higher catastrophe losses in 2012. As described above, the impacts of the merger in 2012 included the gain on bargain purchase, partially offset by Transaction Costs and the net impact from the inclusion of TransRe’s results in 2012. As described above, the increase in catastrophe losses in 2012 from 2011 reflects the fact that we incurred significant losses from Super Storm Sandy in 2012.
(1) Totals exclude elimination of minor reinsurance activity between segments which is reported in corporate activities.
(5) The combined ratio is the sum of the loss ratio and expense ratio, all as determined in accordance with GAAP. The combined ratio represents the percentage of each premium dollar a reinsurance or insurance company has to spend on net loss and LAE, and commission, brokerage and other underwriting expenses.
The earnings before income taxes of our total reinsurance and insurance segments in 2012 increased from 2011, primarily reflecting merger impacts in 2012, and, to a lesser extent, higher other income, partially offset by higher catastrophe losses in 2012. As described above, the impacts of the merger in 2012 included the net impact from the inclusion of TransRe’s results in 2012. Other income in 2012 includes a $23.5 million gain from the settlement of a dispute between TransRe and AIG. As described above, we incurred significant catastrophe losses from Super Storm Sandy in 2012.
(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, net realized capital gains, OTTI losses, other income, other operating expenses, amortization of intangible assets or interest expense. Underwriting profit is a non-GAAP financial measure and does not replace net earnings 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.
Reinsurance Segment - Property. The increases in gross premiums written, net premiums earned and commissions, brokerage and other underwriting expenses in 2013 from 2012 primarily reflect the impact from the merger, specifically related to the inclusion of operations from TransRe for the entire year for 2013, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012.
Absent the impact from the merger, gross premiums written and net premiums earned would have decreased in 2013 from 2012. The decrease in gross premiums written reflects an increasingly competitive reinsurance market, which is expanding its capacity despite the lack of market need, as well as decisions made by TransRe in recent years to non-renew or reduce participation on certain potentially less profitable treaties and shift certain business from proportional to potentially more profitable non-proportional exposure. The decrease in net premiums earned primarily reflects a decrease in gross premiums written in recent quarters. In addition, the decrease in both gross premiums written and net premiums earned reflects the absence of significant assumed reinstatement premiums, compared with $25.3 million recorded in 2012 related to Super Storm Sandy.
The increase in net losses and LAE primarily reflects the inclusion of operations from TransRe for the entire year for 2013, compared with the 300 day period subsequent to the TransRe Acquisition Date for 2012, partially offset by a lower loss ratio in the current accident year including an absence of catastrophe losses in 2013, compared with $26.2 million of catastrophe losses, net of reinsurance, incurred in 2012 related to Super Storm Sandy.
Net losses and LAE for 2013 include $39.4 million of favorable development of prior accident year loss reserves, compared with $31.2 million of favorable development in 2012. Of the $39.4 million favorable development in 2013, $35.7 million related to certain medical malpractice treaties, or “the Malpractice Treaties.” Under the terms of the Malpractice Treaties, the increased underwriting profits created by the favorable development are to be retained by the cedants. As a result, TransRe recorded an offsetting increase in profit commission expense incurred. The remaining $3.7 million of favorable development related to a variety of casualty & other lines of business. The $39.4 million of favorable development in 2013 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods in the casualty & other lines of business. The $39.4 million favorable development did not impact the assumptions used in estimating TransRe’s loss and LAE liabilities for business earned in 2013. For 2012, the $31.2 million favorable development related to favorable loss development from prior accident years on loss and LAE reserves acquired on the TransRe Acquisition Date.
The increase in commissions, brokerage and other underwriting expenses primarily reflects the diminished favorable impact arising from the acquisition method of accounting, as further explained below, and to a lesser extent, the $35.7 million of profit commission expense incurred related to the Malpractice Treaties, as described above.
(4) The expense ratio is derived by dividing the amount of commission, brokerage and other underwriting expenses by net premiums earned, all as determined in accordance with GAAP.
Catastrophe losses, net of reinsurance, were $58.8 million in 2013, $191.7 million in 2012 and $74.3 million in 2011. Catastrophe losses in 2013 include flooding in Colorado in September 2013 and severe weather in the Midwestern U.S., including tornados in Oklahoma in May 2013. Catastrophe losses in 2012 include $155.0 million of net losses from Super Storm Sandy in October 2012. In addition, there was $6.2 million of ceded premiums related to Super Storm Sandy in 2012. Catastrophe losses in 2011 primarily reflect net losses from severe weather, particularly tornados, in the Southeastern and Midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the East Coast of the U.S. in August 2011. In addition, RSUI incurred a $14.4 million property loss arising from the magnitude 5.8 earthquake that occurred in Northern Virginia in August 2011. This earthquake was not classified as a catastrophic event by the property and casualty industry.
Net loss and LAE for 2013 reflect $25.9 million of favorable prior accident year development on casualty loss reserves, compared with $48.1 million of favorable prior accident year development in 2012 and $56.2 million of net favorable prior accident year development in 2011. For 2013, the $25.9 million favorable development related primarily to umbrella/excess liability and professional liability lines of business, primarily for the 2005 through 2010 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. For 2012, the $48.1 million favorable development related primarily to the umbrella/excess liability, general liability, professional liability and D&O liability lines of business primarily for the 2005 through 2008 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. For 2011, the $56.2 million of net favorable development related primarily to the umbrella/excess, general liability and professional liability lines of business, primarily for the 2003 through 2008 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. The 2011 net favorable development was partially offset by unfavorable prior accident year development in the D&O liability line of business, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year.
With respect to the $25.9 million of favorable prior accident year development on casualty loss reserves in 2013, actual losses from prior accident years for such lines of business, which include both loss payments and case reserves, were lower than expected through December 31, 2013. The amount of lower actual losses than expected, expressed as a percentage of carried loss and LAE reserves at the beginning of the year, was 0.2 percent. Such reduction did not impact the assumptions used in estimating RSUI’s loss and LAE.
Capitol. The increase in gross premiums written in 2013 from 2012, and in 2012 from 2011, primarily reflects growth in Capitol’s property and casualty lines of business and, to a lesser extent, Capitol’s surety lines of business. Net premiums earned increased in 2013 compared with 2012 primarily reflecting an increase in gross premiums written in recent quarters. Net premiums earned decreased in 2012 from 2011 as a result of lower gross premiums written during the third and fourth quarters of 2011 compared with gross premiums written in the third and fourth quarters of 2010.
The increase in net loss and LAE in 2013 from 2012, and in 2012 from 2011, primarily reflects the impact of net unfavorable prior accident year development on loss reserves. Net loss and LAE for 2013 reflect $25.8 million of net unfavorable development, compared with $13.2 million of net unfavorable development in 2012 and $5.0 million of net unfavorable development in 2011. For 2013, the $25.8 million net unfavorable development includes $19.4 million of unfavorable development related to certain casualty lines of business and certain specialty casualty classes of business written through a program administrator in connection with a terminated program, or the “Terminated Program,” primarily in the 2010 and 2009 accident years. Net unfavorable development also includes $10.4 million of net unfavorable development on ongoing lines of business, partially offset by $4.0 million of favorable development from Capitol’s asbestos-related illness and environmental impairment reserves. The $10.4 million of net unfavorable development on ongoing lines of business in 2013 is from workers’ compensation and certain other casualty lines of business, and related primarily to unfavorable loss emergence on a few individual claims, partially offset by favorable development on surety lines of business. For 2012, the $13.2 million net unfavorable development includes $22.2 million unfavorable development related to the Terminated Program in the 2010 and 2009 accident years, partially offset by net favorable development in certain of Capitol’s casualty and surety lines of business. For 2011, the $5.0 million net unfavorable development includes $14.6 million of unfavorable development related to the Terminated Program, partially offset by net favorable development in certain of Capitol’s casualty lines of business. The unfavorable development related to the Terminated Program in 2013, 2012 and 2011 reflect continued unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
The increase in Capitol’s underwriting loss in 2013 from 2012 primarily reflects an increase in loss and LAE, partially offset by an increase in net premiums earned, all as discussed above. The increase in Capitol’s underwriting loss in 2012 from 2011 primarily reflects an increase in loss and LAE and commissions, brokerage and other underwriting expenses and a decrease in net premiums earned, all as discussed above.
Net Realized Capital Gains. Net realized capital gains in 2013 related primarily to sales of equity securities. In addition, net realized capital gains in 2013 includes a realized capital loss of $5.0 million relating to a non-cash impairment charge for certain finite-lived intangible assets at Capitol. Net realized capital gains in 2012 and 2011 relate primarily to sales of equity securities in the energy sector, including a gain from the sale in January 2012 of shares of common stock of Exxon Mobil held at the insurance segment level.
Other Than Temporary Impairment Losses. OTTI losses in 2013 reflect $44.0 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Upon the ultimate disposition of 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. Of the $44.0 million of OTTI losses, $42.6 million related to equity securities, primarily in the chemical and energy sectors, and $1.4 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in fair value of such securities relative to their cost as of the balance sheet date.
OTTI losses in 2012 reflect $2.9 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $2.9 million incurred during 2012, $1.7 million related to equity securities, primarily in the energy sector, and $1.2 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in fair value of such securities relative to their cost as of the balance sheet date.
After adjusting the cost basis of securities for the recognition of OTTI losses, the remaining gross unrealized investment losses for debt and equity securities as of December 31, 2013 were deemed to be temporary, based on, among other factors: (i) the duration of time and the relative magnitude to which fair values of these securities had been below cost were not indicative of an OTTI loss (for example, no equity security was in a
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 and equity securities as of December 31, 2013.
The decrease in earnings before income taxes in 2013 compared with 2012 primarily reflects the absence of a gain on bargain purchase in 2013, which was significant in 2012, and to a lesser extent, higher interest expense in 2013, partially offset by lower corporate administration expense in 2013. Higher interest expense is due to the issuance of the 2022 Senior Notes (as defined on page 82 of this Form 10-K) on June 26, 2012. The lower corporate administration expense in 2013 is due primarily to the absence of Transaction Costs, which amounted to $33.8 million in 2012, and to a lesser extent, the impact of freezing and/or termination of certain parent-level employee benefit plans. In 2013, we determined to: (i) freeze the benefits associated with our unfunded, noncontributory defined benefit pension plan for parent-level executives, effective December 31, 2013; and (ii) terminate our two retiree health plans for parent-level executives and employees, effective September 30, 2013. As a result of these decisions, we recorded a pre-tax $8.8 million reduction to corporate administration expense in 2013.
Net realized capital gains in 2013 primarily reflect the sale of Homesite on December 31, 2013, partially offset by sales of equity securities at a realized capital loss. Net realized capital gains in 2012 and 2011 primarily reflect gains from the sale of shares of Exxon Mobil Corporation common stock held at the corporate-level in the first quarter of 2012 and the fourth quarter of 2011.
The Homesite results for 2013 (prior to its sale on December 31, 2013) primarily reflect favorable development on Homesite’s loss and LAE reserves and favorable levels of weather-related claims. The Homesite losses in 2012 reflect the impact of increased homeowners insurance claims from severe weather during the year, and $13.2 million of losses representing our share of Homesite’s loss from Super Storm Sandy in October 2012, partially offset by the favorable impact of higher premium rates. Homesite losses in 2011 primarily reflect the impact of increased homeowners insurance claims from severe weather, particularly tornados, in the southeastern and midwestern U.S., as well as from Hurricane Irene. Homesite losses in 2011 also reflect a tax valuation adjustment.
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 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 loss 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 accident year loss reserve development. The following table presents the reserves established in connection with the loss and LAE of our reinsurance and insurance subsidiaries on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate loss (including for incurred but not reported) and LAE.
(1) Primarily consists of assumed: D&O liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; surety; asbestos-related illness and environmental impairment liability; and credit.
(2) Primarily consists of direct: umbrella/excess; D&O liability; professional liability; and general liability.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2013 and December 31, 2012
Gross and net loss and LAE reserves as of December 31, 2013 decreased from December 31, 2012, reflecting a decrease in our reinsurance segment loss and LAE reserves, partially offset by a slight increase in our insurance segment loss and LAE reserves. The decrease in gross and net loss and LAE reserves in the reinsurance segment primarily reflects favorable development from prior accident years and payments related to catastrophic events occurring in prior years. The slight increase in gross and net loss and LAE reserves in the insurance segment primarily reflects the impact of higher net premiums earned in 2013, partially offset by the impact of property loss claims resulting from Super Storm Sandy paid by RSUI in 2013.
Changes in Gross and Net Loss and LAE Reserves between December 31, 2012 and December 31, 2011
(3) Approximately 94.8 percent of our reinsurance recoverables balance as of December 31, 2013 was due from reinsurers having an A.M. Best financial strength rating of A (Excellent) or higher.
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.
Each of our 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 relating to the actual ultimate losses that will arise from the claims. Due to the inherent uncertainties in the process of establishing these liabilities, the actual ultimate loss from a claim is likely to differ, perhaps materially, from the liability initially recorded.
of business, estimating the ultimate liabilities for unpaid loss 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, our insurance operating subsidiaries will generally use actuarial projections in setting reserves for all casualty lines of business.
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 much 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, D&O 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.
Methodologies and Assumptions. Our reinsurance and insurance subsidiaries use a variety of techniques that employ significant judgments and assumptions to establish the liabilities for unpaid loss and LAE recorded at the balance sheet date. These techniques include detailed statistical analyses of past claims reporting, settlement activity, claims frequency, internal loss experience, changes in pricing or coverages and severity data when sufficient information exists to lend statistical credibility to the analyses. More subjective techniques are used when statistical data is insufficient or unavailable. These liabilities also reflect implicit or explicit assumptions regarding the potential effects of future inflation, judicial decisions, changes in laws and recent trends in such factors, as well as a number of actuarial assumptions that vary across our reinsurance and insurance subsidiaries and across lines of business. This data is analyzed by line of business, coverage, accident year or underwriting year and reinsurance contract type, as appropriate.
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 past experience of our operating subsidiaries, modified for current trends. These emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value.
Loss Frequency and Severity. Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described above. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs and changes in economic conditions or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to our reinsurance or insurance operating subsidiary. The length of the loss reporting lag affects their ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags), as well as the amount of reserves needed for IBNR. If the actual level of loss frequency and severity is higher or lower than expected, the ultimate losses will be different than management’s estimates. A small percentage change in an estimate can
result in a material effect on our reported earnings. The following table reflects the impact of changes, which could be favorable or unfavorable, in frequency and severity on our loss estimates for claims occurring in 2013:
Our net reserves for loss and LAE of $10.7 billion as of December 31, 2013 relate to multiple accident years. Therefore, the impact of changes in frequency or severity for more than one accident year could be higher or lower than the amounts reflected above. We believe the above analysis provides a reasonable benchmark for sensitivity as we believe it is within historical variation for our reserves. Currently, none of the scenarios is believed to be more likely than the other. See Note 1(k) and Note 6 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 loss and LAE.
Reinsurance Segment - Casualty & Other. Of the $39.4 million favorable development in 2013, $35.7 million related to the Malpractice Treaties. Under the terms of the Malpractice Treaties, the increased underwriting profits created by the favorable development are to be retained by the cedants. As a result, TransRe recorded an offsetting increase in profit commission expense incurred. The remaining $3.7 million of favorable development related to a variety of casualty & other lines of business. The $39.4 million of favorable development in 2013 reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods in the casualty & other lines of business.
RSUI - Casualty. For 2013, the $25.9 million favorable development related primarily to umbrella/excess liability and professional liability lines of business, primarily for the 2005 through 2010 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. For 2012, the $48.1 million favorable development related primarily to the umbrella/excess liability, general liability, professional liability and D&O liability lines of business primarily for the 2005 through 2008 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. For 2011, the $56.2 million net favorable development related primarily to the umbrella/excess, general liability and professional liability lines of business, primarily for the 2003 through 2008 accident years, and reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business. The 2011 net favorable development was partially offset by unfavorable prior accident year development in the D&O liability line of business, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year.
RSUI - Property & Other. For 2013, the $8.0 million includes $8.5 million of unfavorable development from Hurricane Katrina in 2005, which arose from a significant claim that settled for a larger amount than previously estimated due to an adverse court ruling, partially offset by net favorable development from other property reserves. For 2012, the $17.0 million includes $9.7 million of unfavorable development from Hurricane Ike in 2008.
Asbestos and Environmental Impairment Reserves. Loss and LAE include amounts for risks relating 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, particularly for those occurring in 1985 and prior, which represents the majority of TransRe’s asbestos-related illness and environmental impairment reserves. This uncertainty is due to 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, 2013. See Note 12(d) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” and pages 30 and 31 of this Form 10-K for additional information on loss and LAE for risks relating to asbestos-related illness and environmental impairment.
A three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Assets classified as Level 3 principally include certain residential mortgage-backed securities, or “RMBS,” commercial mortgage-backed securities, or “CMBS,” other asset-backed securities, partnership investments and non-marketable equity investments. The valuation of Level 3 assets requires the greatest degree of judgment, as these valuations are based on techniques that use significant inputs that are unobservable. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Our assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment. In making the assessment, we consider factors specific to the asset. Some Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained.
Mortgage and asset-backed securities are initially valued at the transaction price. Subsequently, we use widely accepted valuation practices that produce a fair value measurement by comparison to transactions in similarly structured instruments, use of discounted cash flows, or option adjusted spread analyses. Unobservable inputs, significant to the measurement and valuation of mortgage and asset-backed securities, include assumptions about prepayment speed and collateral performance, including default, delinquency and loss severity rates. Significant changes to any one of these inputs, or combination of inputs, could significantly change the fair value measurement for these securities.
We hold our equity and debt securities as available-for-sale, or “AFS,” and as such, these securities are recorded at fair value. We continually monitor the difference between cost and the estimated fair value of our investments, which involves uncertainty as to whether declines in value are temporary in nature. The analysis of any individual security’s decline in value is performed in its functional currency. If the decline of a particular investment is deemed temporary, we record the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, we write our cost-basis or amortized cost-basis down to the fair value of the investment and record an OTTI loss on our statement of earnings. In addition, any portion of such decline that related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income, rather than charged against earnings.
To the extent that an equity security in an unrealized loss position is not impaired based on the initial review described above, we then further evaluate such equity security and deem it to be other-than-temporarily impaired if it has been in an unrealized loss position for 12 months or more or if its unrealized loss position is greater than 50 percent of its cost, absent compelling evidence to the contrary.
In developing the cash flow analyses for debt securities, we consider various factors for the different categories of debt securities. For municipal bonds, we take into account the taxing power of the issuer, source of revenue, credit risk and credit enhancements and pre-refunding. For mortgage and asset-backed securities, we discount our best estimate of future cash flows at an effective rate equal to the original effective yield of the security or, in the case of floating rate securities, at the current coupon. Our models include assumptions about prepayment speeds, default and delinquency rates, and underlying collateral (if any), as well as credit ratings, credit enhancements and other observable market data. For corporate bonds, we review business prospects, credit ratings and available information from asset managers and rating agencies for individual securities.
We may ultimately record a realized loss after having originally concluded that the decline in value was temporary. 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 assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral, and unfavorable changes in economic conditions or social trends, interest rates or credit ratings.
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 at 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 values at 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. Other
Our consolidated balance sheet as of December 31, 2013 includes goodwill of $99.7 million related to RSUI, Capitol, BKI and Kentucky Trailer, and intangible assets, net of amortization, of $127.3 million related to TransRe, RSUI, Capitol, BKI 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.
General. In general, we follow a policy of maintaining a relatively liquid financial condition at the parent company. This policy has permitted us to expand our operations through internal growth at our subsidiaries and through acquisitions of, or substantial investments in, operating companies. As of December 31, 2013, we held total marketable securities and cash of $840.0 million, compared with $731.7 million as of December 31, 2012. The increase during 2013 primarily reflects the receipt of dividends from TransRe, RSUI and Capitol, partially offset by investments in non-public equity securities and cash contributions to AIHL Re and ACC. The $840.0 million is comprised of $208.7 million at the parent company, $459.8 million at AIHL and $171.5 million at the TransRe holding company. We believe that we have and will have adequate internally generated funds, cash resources and unused credit facilities to provide for the currently foreseeable needs of our business, and we had no material commitments for capital expenditures as of December 31, 2013.
Stockholders’ equity attributable to Alleghany stockholders was approximately $6.9 billion as of December 31, 2013, compared with approximately $6.4 billion as of December 31, 2012. The increase in stockholders’ equity primarily reflects net earnings and an increase in unrealized appreciation on our equity securities portfolio in 2013, partially offset by a decrease in unrealized appreciation on our debt securities portfolio in 2013, reflecting a general rise in interest rates and, to a lesser extent, repurchases of our common stock. As of December 31, 2013, we had 16,766,192 shares of our common stock outstanding, compared with 16,890,623 shares of our common stock outstanding as of December 31, 2012.
Our reinsurance and insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid by them without prior approval of the relevant regulatory authorities. These limitations have not affected our ability to meet our obligations.
With respect to TransRe, its operating subsidiaries could ordinarily pay dividends without regulatory approval based on statutory surplus. However, for a period of 24 months following the TransRe Acquisition Date, TRC is prohibited from paying a dividend to TransRe in excess of $200.0 million in the aggregate in any
given 12 month period without the prior approval of the New York State Department of Financial Services. In 2013, TRC paid dividends of $200.0 million to TransRe, of which $150.0 million was in turn paid to Alleghany.
With respect to AIHL, its operating subsidiaries could also pay additional dividends without regulatory approval based on statutory surplus. Of the aggregate total equity of our insurance operating subsidiaries as of December 31, 2013 of $2.0 billion, a maximum of $60.6 million was available for dividends without prior approval of the applicable insurance regulatory authorities. In 2013, RSUI paid AIHL a cash dividend of $100.0 million and Capitol paid AIHL a cash dividend of $15.0 million. In 2012, Capitol paid AIHL a cash dividend of $15.0 million. In 2011, RSUI paid AIHL a cash dividend of $100.0 million and Capitol paid AIHL a cash dividend of $15.0 million.
During 2013, we repurchased an aggregate of 113,160 shares of our common stock in the open market for $40.4 million, at an average price per share of $356.92. During 2012, we repurchased an aggregate of 53,346 shares of our common stock in the open market for $17.8 million, at an average price per share of $333.08. During 2011, we repurchased an aggregate of 399,568 shares of our common stock in the open market for $120.3 million, at an average price per share of $301.14.
Dividends. From 1987 through 2011, we declared stock dividends in lieu of cash dividends every year except 1998, when our wholly-owned subsidiary, Chicago Title Corporation, was spun off to our stockholders. Our Board of Directors determined not to declare a dividend, cash or stock, for 2012 or 2013.
In July 2013, AIHL invested $250.0 million in Ares Management LLC, or “Ares,” a privately-held 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. AIHL’s investment in Ares is reported in other invested assets on our consolidated balance sheets.
using the lowest of the S&P’s, Moody’s or Fitch’s Ratings rating. In this regard, the overall weighted-average credit quality rating of our debt securities portfolio as of December 31, 2013 was AA-. Although many of our debt securities, which consist predominantly of municipal bonds, are insured by third party financial guaranty insurance companies, the impact of such insurance was not significant to the debt securities credit quality rating as of December 31, 2013. As of December 31, 2013, the ratings of our debt securities portfolio were as follows:
In the event paid losses accelerate beyond the ability of our reinsurance and insurance subsidiaries to fund these paid losses from current cash balances, current operating cash flow, coupon 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 catastrophic 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.
Fair Value. The carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2013 and 2012 were as follows:
“Level 3”-Valuations are based on techniques that use significant inputs that are unobservable. The valuation of Level 3 assets requires the greatest degree of judgment. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, we consider factors specific to the asset. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Some Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained. Assets classified as Level 3 principally include certain RMBS, CMBS, other asset-backed securities, partnership investments and non-marketable equity investments. See Note 1(c) to Notes to Consolidated Financial Statements set forth in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for our accounting policy on fair value.
We employ specific control processes to determine the reasonableness of the fair values of our financial assets and liabilities. Our processes are designed to ensure that the values received or internally estimated are accurately recorded and that the data inputs and the valuation techniques used are appropriate, consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. We assess the reasonableness of individual security values received from valuation service providers through various analytical techniques. In addition, we validate the reasonableness of fair values by comparing information obtained from our valuation service providers to other third party valuation sources for selected securities. We also validate prices obtained from brokers for selected securities through reviews by those who have relevant expertise and who are independent of those charged with executing investing transactions.
* Includes Austria, Belgium, the Czech Republic, Denmark, Finland, Luxembourg, Norway, Sweden and Switzerland.
Municipal Bonds. The following table provides the fair value of our municipal bonds as of December 31, 2013, categorized by state and revenue source. Special revenue bonds are debt securities for which the payment of principal and interest is available solely from the cash flows of the related projects. As issuers of revenue bonds do not have the ability to draw from tax revenues or levy taxes to fund obligations, revenue bonds may carry a greater risk of default than general obligation bonds.
In February 2013, the FASB issued guidance on the amounts reclassified out of accumulated other comprehensive income. Other comprehensive income includes gains and losses that are initially excluded from net earnings for a given period, and later reclassified out of accumulated other comprehensive income into net earnings. This guidance requires companies to disclose information about reclassifications out of accumulated other comprehensive income in one place. This guidance is effective for interim and annual periods beginning after December 15, 2012. Alleghany adopted this guidance in the first quarter of 2013, and the implementation did not have an impact on its 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 and Supplementary Data” of this Form 10-K.
In December 2011, the FASB issued guidance on disclosure requirements related to offsetting arrangements. The guidance provides for additional financial statement disclosure regarding offsetting and related arrangements to enable financial statement users to understand the effect of those arrangements on an entity’s financial position. This guidance is effective for interim and annual reporting periods beginning on or after January 1, 2013. Alleghany adopted this guidance in the first quarter of 2013, and the implementation did not have a material impact on its results of operations and financial condition.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the results of Alleghany Corporation and subsidiaries’ operations and their cash flows for the year ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
The accompanying consolidated financial statements include the results of Alleghany and its wholly-owned and majority-owned or controlled subsidiaries and have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”). All significant inter-company balances and transactions have been eliminated in consolidation. The results of TransRe are included in Alleghany’s consolidated results beginning from the TransRe Acquisition Date, except with respect to “Supplemental Pro Forma Information” included in Note 2(e). In addition, the results of BKI have been included in Alleghany’s consolidated results beginning April 26, 2012 and the results of Kentucky Trailer have been included in Alleghany’s consolidated results beginning August 30, 2013.
The portion of stockholders’ equity, net earnings and accumulated other comprehensive income that is not attributable to Alleghany stockholders is presented on the Consolidated Balance Sheets, the Consolidated Statements of Earnings and Comprehensive Income and the Consolidated Statements of Changes in Stockholders’ Equity as noncontrolling interest.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Alleghany relies on historical experience and on various other assumptions that it believes to be reasonable under the circumstances to make judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from those reported results to the extent that those estimates and assumptions prove to be inaccurate. Changes in estimates are reflected in the consolidated statement of earnings and comprehensive income in the period in which the change is made.
AFS securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to AFS securities, as well as partnership investments that Alleghany accounts for as AFS, are excluded from earnings and reflected in comprehensive income, and the cumulative effect is reported as a separate component of stockholders’ equity until realized. If a decline in fair value is deemed to be other than temporary, the investment is written down to its fair value and the amount of the write-down is recorded as an other than temporary impairment (“OTTI”) loss on the statement of earnings. In addition, any portion of such decline that related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income, rather than against earnings.
Although Alleghany is responsible for the determination of the fair value of the financial assets and the supporting methodologies and assumptions, it employs 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 internal valuation models.
“Level 2”-Valuations are based on direct and indirect observable inputs other than quoted market prices included in Level 1. Level 2 inputs include quoted prices for similar assets in active markets and inputs other than quoted prices that are observable for the asset, such as the terms of the security and market-based inputs. Terms of the security include coupon, maturity date, and any special provisions that may, for example, enable the investor, at its election, to redeem the security prior to its scheduled maturity date. Market-based inputs include interest rates and yield curves that are observable at commonly quoted intervals and current credit rating(s) of the security. Level 2 assets generally include short-term investments and most debt securities. Alleghany’s Level 2 liabilities consist of the senior notes.
“Level 3”-Valuations are based on techniques that use significant inputs that are unobservable. The valuation of Level 3 assets requires the greatest degree of judgment. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Alleghany’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, Alleghany considers factors specific to the asset. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Some Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained. Assets classified as Level 3 principally include certain residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), other asset-backed securities, partnership investments and non-marketable equity investments.
The impact of prepayment speeds on fair value is dependent on a number of variables including whether the securities were purchased at a premium or discount. A decrease in interest rates generally increases the assumed rate of prepayments, and an increase in interest rates generally decreases the assumed speed of prepayments. Increased prepayments increase the yield on securities purchased at a discount, and reduce the yield on securities purchased at a premium. In a decreasing prepayment
environment, yields on securities purchased at a discount are reduced but are increased for securities purchased at a premium. Changes in default assumptions on underlying collateral are generally accompanied by directionally similar changes in other collateral performance factors, but generally result in a directionally opposite change in prepayment assumptions.
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 at 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 values at 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. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and those intangible assets that have an indefinite useful life are not subject to amortization.
With respect to goodwill, a qualitative assessment is first made to determine whether it is necessary to perform quantitative testing. This initial assessment includes, among others, consideration of: (i) past, current and projected future earnings and equity; (ii) recent trends and market conditions; and (iii) valuation metrics involving similar companies that are publicly-traded and acquisitions of similar companies, if available. If this initial qualitative assessment indicates that the fair value of an operating subsidiary may be less than its respective carrying amount, a second step is taken, involving a comparison between the estimated fair values of the operating subsidiaries with their respective carrying amounts including goodwill. Under GAAP, fair value refers to the amount for which the entire operating subsidiary may be bought or sold. The methods for estimating operating subsidiary 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. If the carrying value exceeds estimated fair value, there is an indication of potential impairment, and a third step is performed to measure the amount of impairment. The third step involves calculating an implied fair value of goodwill by measuring the excess of the estimated fair value of the operating subsidiaries over the aggregate estimated fair values of the individual assets less liabilities. If the carrying value of goodwill exceeds the implied fair value of goodwill, an impairment charge is recorded for the excess.
Alleghany files a consolidated federal income tax return with its subsidiaries. Following the TransRe Acquisition Date, Alleghany’s consolidated federal income tax return includes as part of its taxable income those items of income of non-U.S. subsidiaries that are subject to U.S. income tax currently, pursuant to Subpart F
income rules of the Internal Revenue Code. 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 carry-forwards. 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. Current tax liabilities or assets are recognized for the estimated taxes payable or refundable on tax returns for the current year.
Basic earnings per share of common stock is based on the average number of shares of common stock, par value $1.00 per share, of Alleghany (“Common Stock”) outstanding during the period, retroactively adjusted for
Assets and liabilities denominated in foreign currencies are translated into U.S. dollars at period-end exchange rates. Income and expense accounts are translated at average exchange rates for the year. The resulting unrealized currency translation gain (loss) for functional currencies is recorded, net of tax, in accumulated other comprehensive income, a component of stockholders’ equity.
Certain prior year amounts have been reclassified to conform to the 2013 presentation of the financial statements.
Pursuant to the terms of the Merger Agreement, on the TransRe Acquisition Date, stockholders of Old TransRe were entitled to receive, in exchange for each share of Old TransRe common stock held, either shares of Common Stock or cash consideration with a value equal to approximately $61.14 (“Per Share Consideration”), which was the sum of (i) 0.145 multiplied by the average of the closing sales prices on the New York Stock Exchange for Common Stock during the five trading days ending the day before the TransRe Acquisition Date (the “Average Closing Price”) and (ii) $14.22, as more fully described in the Merger Agreement. In total, Alleghany paid to the stockholders of Old TransRe consideration of approximately $3.5 billion, consisting of cash consideration of $816.0 million and stock consideration of 8,360,959 shares of Common Stock. The stock consideration was tax free to Old TransRe stockholders.
(1) As noted previously, the Merger Agreement determined aggregate consideration paid based on the Average Closing Price. For GAAP purposes, the purchase price is determined based on the closing price of the Common Stock as of the TransRe Acquisition Date.
Pursuant to the terms of the Merger Agreement, each outstanding stock option to acquire Old TransRe common stock was converted into the right to receive a cash payment based on its Black-Scholes value on the TransRe Acquisition Date based on assumptions set forth in the Merger Agreement. As of the TransRe Acquisition Date, the value of the Old TransRe stock options was determined to be $11.1 million, which was paid in March 2012.
TransRe Senior Notes - Adjustments of the TransRe Senior Notes to their estimated fair value based on prevailing interest rates and other factors as of the TransRe Acquisition Date. See Note 8(b) for additional information on the TransRe Senior Notes.
Loss and LAE reserves - Adjustment resulting from the difference between the estimated fair value and the historical carrying value of TransRe’s unpaid loss and LAE, net of related reinsurance recoverable, as of the TransRe Acquisition Date. The estimated fair value consists of the present value of the net loss reserves plus a risk premium. This will be amortized over the estimated payout pattern of net reserves as of the TransRe Acquisition Date.
Leases - Adjustment resulting from the difference between the estimated fair value of TransRe’s operating leases for its office space and its operating lease commitments, as of the TransRe Acquisition Date. This will be amortized on a straight-line basis over the future remaining terms of the operating leases as of the TransRe Acquisition Date.
The increase in pro forma net earnings in 2012 from 2011 reflects significantly lower catastrophe losses incurred by TransRe, partially offset by higher catastrophe losses incurred by RSUI.
(3) Represents goodwill and other intangible assets related to the acquisition of BKI on April 26, 2012, which was purchased for $55.0 million, including estimated contingent consideration of $8.0 million based on future profitability, and to the acquisition of a controlling equity interest in Kentucky Trailer on August 30, 2013 for $24.9 million. On January 2, 2014, Alleghany exercised its option to increase its common equity interest in Kentucky Trailer to 80.0 percent for an additional investment of $15.0 million.
The economic useful lives of intangible assets are as follows: agency relationships - 15 years; state and foreign insurance licenses - indefinite; trade names - indefinite; brokerage and reinsurance relationships - 15 years; renewal rights - between 5 and 14 years; value of business-in-force - 1 year; loss and LAE reserves - 15 years; leases - 10 years; and internally developed software - 2.5 years.
(2) Includes partnership and non-marketable equity investments accounted for on an AFS basis, and approximates cost.
The amortized cost and estimated fair value of debt securities as of December 31, 2013 by contractual maturity are shown below. 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.
As of December 31, 2013, non-income producing invested assets were insignificant.
The proceeds from sales of AFS securities were $8.6 billion, $3.0 billion and $1.9 billion in 2013, 2012 and 2011, respectively.
$63.1 million of capital gains from the sales of shares of common stock of Exxon Mobil Corporation in January 2012. The amount of gross realized capital gains and gross realized capital losses in 2013, 2012 and 2011 were as follows:
Alleghany holds its equity and debt securities as AFS, and as such, these securities are recorded at fair value. Alleghany continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. The analysis of any individual security’s decline in value is performed in its functional currency. If the decline of a particular investment 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 cost-basis or amortized cost-basis down to the fair value of the investment and records an OTTI loss on its statement of earnings. In addition, any portion of such decline that relates to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income, rather than charged against earnings.
If Alleghany intends to sell, or it is more likely than not that Alleghany will sell, a debt security before recovery of its amortized cost basis, the total amount of the unrealized loss position is recognized as an OTTI loss in earnings. To the extent that a debt security that is in an unrealized loss position is not impaired based on
OTTI losses for 2011 reflect $3.6 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $3.6 million of OTTI losses, $3.1 million related to equity security holdings, primarily in the materials and financial services sectors, and $0.5 million related to debt security holdings. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity of the declines in fair value of such securities relative to their cost as of the balance sheet date.
After adjusting the cost basis of securities for the recognition of OTTI losses, the remaining gross unrealized investment losses for debt and equity securities as of December 31, 2013 were deemed to be temporary, based on, among other factors: (i) the duration of time and the relative magnitude to which the fair value of these investments had been below cost were not indicative of an OTTI loss (for example, no equity security was in a continuous unrealized loss position for 12 months or more as of December 31, 2013); (ii) the absence of compelling evidence that would cause Alleghany to call into question the financial condition or near-term business prospects of the issuer of the investment; and (iii) Alleghany’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery.
As of December 31, 2013 and 2012, gross unrealized losses and related fair values for equity securities and debt securities, grouped by duration of time in a continuous unrealized loss position, were as follows:
As of December 31, 2013, Alleghany held a total of 1,149 debt securities and equity securities that were in an unrealized loss position, of which 64 securities, all debt securities, were in an unrealized loss position continuously for 12 months or more. Unrealized losses associated with the 64 debt securities consisted primarily of losses related to RMBS and, to a lesser extent, municipal bonds and U.S. corporate bonds.
As of December 31, 2013, substantially all of Alleghany’s debt securities were rated investment grade, with approximately 2.2 percent of debt securities having issuer credit ratings that were below investment grade or not rated.
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 (the “Funds”), which are managed by Pillar Holdings. 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 investment. As of December 31, 2013, Alleghany’s carrying value in the Pillar Investments, as determined under the equity method of accounting, was $227.7 million, which is reported in other invested assets on its consolidated balance sheets.
In July 2013, AIHL invested $250.0 million in Ares, a privately-held 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. AIHL’s investment in Ares is reported in other invested assets on Alleghany’s consolidated balance sheets.
Alleghany’s 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, improve risk-adjusted portfolio returns, and enable them to increase gross premium writings and risk capacity without requiring additional capital. Although our reinsurance and insurance subsidiaries purchase reinsurance from highly-rated third party reinsurers, if the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, Alleghany’s 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 recoverables and Alleghany’s reinsurance and insurance subsidiaries reinsure portions of the risks they underwrite or assume with multiple reinsurance programs.
Information regarding concentration of Alleghany’s reinsurance recoverables and the ratings profile of its reinsurers as of December 31, 2013 is as follows:
(3) Approximately 94.8 percent of Alleghany’s reinsurance recoverables balance as of December 31, 2013 was due from reinsurers having an A.M. Best Company, Inc. financial strength rating of A (Excellent) or higher.
Alleghany had no allowance for uncollectible reinsurance as of December 31, 2013 and 2012.
Reinsured loss and LAE ceded included in Alleghany’s consolidated statements of earnings were $263.0 million, $290.4 million and $140.1 million for 2013, 2012 and 2011, respectively.
The following table indicates property and casualty premiums written and earned for 2013, 2012 and 2011:
(2) Represents the carrying value of TransRe’s net reserves acquired in the merger. Gross loss and LAE reserves and ceded loss and LAE reserves as of the TransRe Acquisition Date were $9,627.8 million and $471.7 million, respectively.
Gross loss and LAE reserves as of December 31, 2013 decreased from December 31, 2012, reflecting a decrease in our reinsurance segment loss and LAE reserves, partially offset by a slight increase in our insurance segment loss and LAE reserves. The decrease in gross loss and LAE reserves in the reinsurance segment primarily reflects favorable development from prior accident years and payments related to catastrophic events occurring in prior years. The slight increase in gross loss and LAE reserves in the insurance segment primarily reflects the impact of higher net premiums earned in 2013, partially offset by the impact of property loss claims resulting from Super Storm Sandy paid by RSUI in 2013.
The significant increase in gross loss and LAE reserves as of December 31, 2012 compared with December 31, 2011 is primarily due to reserves acquired as a result of the merger, and to a lesser extent, the impact of Super Storm Sandy.
patterns assumed in earlier periods for such lines of business. The 2011 net favorable development was partially offset by unfavorable prior accident year development in the D&O liability line of business, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year.
Capitol. For 2013, the $25.8 million net unfavorable prior accident year development includes $19.4 million of unfavorable development related to certain casualty lines of business and to certain specialty casualty classes of business written through a program administrator in connection with a terminated program (the “Terminated Program”) in the 2010 and 2009 accident years, and $10.4 million of unfavorable development from workers’ compensation and certain other casualty lines of business, partially offset by $4.0 million of favorable development from Capitol’s asbestos-related illness and environmental impairment reserves. The $10.4 million unfavorable development in 2013 from workers’ compensation and certain other casualty lines of business related primarily to unfavorable loss emergence on a few individual claims, partially offset by favorable development on surety lines of business. For 2012, the $13.2 million net unfavorable development includes $22.2 million unfavorable development related to the Terminated Program in the 2010 and 2009 accident years, partially offset by net favorable development in certain of Capitol’s casualty and surety lines of business. For 2011, the $5.0 million net unfavorable development includes $14.6 million of unfavorable development related to the Terminated Program, partially offset by net favorable development in certain of Capitol’s casualty lines of business. The unfavorable development related to the Terminated Program in 2013, 2012 and 2011 reflect continued unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business.
Borrowings under the Credit Agreement bear a floating rate of interest based in part on Alleghany’s credit rating, among other factors. The Credit Agreement requires that all loans be repaid in full no later than October 15, 2017. The Credit Agreement also requires Alleghany to pay a commitment fee each quarter in a range of between 0.125 and 0.30 percent per annum, based upon Alleghany’s credit rating, on the daily unused amount of the commitments. 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 its inception through December 31, 2013.
On December 14, 2005, TransRe completed a public offering of $750.0 million aggregate principal amount of its 5.75% senior notes due on December 14, 2015 (the “2015 Notes”). Prior to the TransRe Acquisition Date, a portion of the 2015 Notes was repurchased by Old TransRe. As of December 31, 2013, the outstanding principal amount was $667.0 million. 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 Notes”). The TransRe Senior Notes, consisting of the 2015 Notes and the 2039 Notes, are unsecured and unsubordinated general obligations of TransRe and are not guaranteed by Alleghany. Interest on each issuance of TransRe Senior Notes is payable semi-annually. The terms of the TransRe Senior Notes permit redemption prior to their maturity. The indentures under which the TransRe 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 TRC, TRZ or Fair American Insurance and Reinsurance Company. As of the TransRe Acquisition Date, the TransRe Senior Notes were recorded at their estimated fair value of $1.1 billion, and resulted in an effective yield of approximately 3.0 percent for the 2015 Notes and 6.9 percent for the 2039 Notes. See Note 2 for additional information on TransRe and Note 3 for fair value information.
The lower effective tax rate in 2012 primarily reflects the impact of the non-taxable gain on bargain purchase and, to a lesser extent, the impact of higher tax-exempt interest income generated by TransRe from the TransRe Acquisition Date through December 31, 2012, partially offset by the impact of certain non-deductible Transaction Costs. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes, whereas certain non-deductible Transaction Costs resulted in losses before income taxes without a corresponding decrease in income taxes.
The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities as of December 31, 2013 and 2012 are as follows:
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. Alleghany has recognized $15.8 million of deferred tax assets for certain state net operating and capital loss carryovers. A valuation allowance of $15.8 million 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 returns are not currently under examination by the Internal Revenue Service. TransRe’s income tax returns, which all relate to periods prior to the merger with Alleghany, are not currently under examination by the Internal Revenue Service. The following table lists the tax years of Alleghany and TransRe tax returns that remain subject to examination by major tax jurisdictions as of December 31, 2013:
The following table presents a reconciliation of the changes during 2013 in accumulated other comprehensive income attributable to Alleghany stockholders:
Alleghany’s reinsurance and insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid by them without prior approval of insurance regulatory authorities.
With respect to AIHL, its operating subsidiaries could also pay additional dividends without regulatory approval based on statutory surplus. Of the aggregate total equity of Alleghany’s insurance operating subsidiaries as of December 31, 2013 of $2.0 billion, a maximum of $60.6 million was available for dividends without prior approval of the applicable insurance regulatory authorities.
Statutory net income of Alleghany’s reinsurance and insurance subsidiaries was $836.9 million and $448.8 million for the years ended December 31, 2013 and 2012, respectively. Combined statutory capital and surplus of Alleghany’s reinsurance and insurance subsidiaries was $6.5 billion and $5.8 billion as of December 31, 2013 and 2012, respectively. As of December 31, 2013, the amount of statutory capital and surplus necessary to satisfy regulatory requirements was not significant in relation to actual statutory capital and surplus.
In connection with the merger, Alleghany, Merger Sub and Old TransRe, among others, were named as defendants in three putative stockholder class action lawsuits, including one consolidated lawsuit filed in the Court of Chancery of the State of Delaware (the “Court”) and two lawsuits filed in the Supreme Court of the State of New York. Such lawsuits challenged the merger and alleged that Alleghany, Merger Sub and Old TransRe aided and abetted an alleged breach of fiduciary duty by Old TransRe’s board of directors in connection with the merger, among other allegations.
settlement and, on March 13, 2013, the Court entered an order dismissing the consolidated Delaware action without prejudice. On April 25, 2013, one of the two lawsuits filed in the Supreme Court of the State of New York was discontinued. On April 26, 2013, the remaining lawsuit was also discontinued.
On July 14, 2005 (the “Closing Date”), Alleghany completed the sale of its world-wide industrial minerals business, World Minerals, Inc. (“World Minerals”), to Imerys USA, Inc. (the “Purchaser”), a wholly-owned subsidiary of Imerys, S.A., pursuant to a Stock Purchase Agreement, dated as of May 19, 2005, by and among the Purchaser, Imerys, S.A. and Alleghany (the “Stock Purchase Agreement”). Pursuant to the Stock Purchase Agreement, Alleghany undertook certain indemnification obligations, including a general indemnification for breaches of representations and warranties set forth in the Stock Purchase Agreement, and a special indemnification (the “Products Liability Indemnification”) related to products liability claims arising from events that occurred during pre-closing periods, including the period of Alleghany ownership (the “Alleghany Period”). Under the terms of the Stock Purchase Agreement, with respect to products liability claims arising in respect of events occurring during the period prior to the Alleghany Period, Alleghany will provide indemnification at a rate of 100.0 percent for the first $100.0 million of losses arising from such claims, and at a rate of 50.0 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 such period of time is $150.0 million. This indemnification obligation will expire on July 31, 2016. With respect to the Alleghany Period, based on its historical experience and other analyses, in July 2005, Alleghany established a $0.6 million reserve in connection with the Products Liability Indemnification for the Alleghany Period. Such reserve was approximately $0.1 million as of both December 31, 2013 and 2012. The Stock Purchase Agreement provides that Alleghany has no responsibility for products liability claims arising in respect of events occurring after the Closing Date, and that any products liability claims involving both pre-closing and post-closing periods will be apportioned on an equitable basis.
Loss and LAE include amounts for risks relating to asbestos-related illness and environmental impairment. As of December 31, 2013 and 2012, such gross and net reserves were as follows:
As of December 31, 2012, Alleghany had a concentration of market risk in its AFS equity securities portfolio with respect to certain energy sector businesses of $542.2 million.
The reinsurance segment consists of property and casualty reinsurance operations conducted by TransRe’s reinsurance operating subsidiaries (see Note 2 for additional information on TransRe) and is further reported by major product lines-property and casualty & other. TransRe provides property and casualty reinsurance to insurers and reinsurers through brokers and on a direct basis to ceding companies. TransRe also writes a modest amount of insurance business, which is included in the reinsurance segment. Approximately half 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 primary components of “corporate activities” are Alleghany Properties, Stranded Oil, Alleghany’s investments in Homesite (prior to its sale on December 31, 2013) and ORX and other activities at the parent level. Beginning April 26, 2012 and August 30, 2013, corporate activities also includes the operating results of BKI and Kentucky Trailer, respectively.
(3) Includes amortization associated with deferred acquisition costs of $973.5 million, $578.1 million and $141.4 million for the years ended December 31, 2013, 2012 and 2011, respectively.
Foreign net premiums earned in 2013 and from the TransRe Acquisition Date through December 31, 2012 were $1,569.1 million and $1,430.6 million, respectively. The foreign country in which Alleghany generates the largest amount of premium revenues is the United Kingdom. Net premiums earned by operations in the United Kingdom in 2013 and from the TransRe Acquisition Date through December 31, 2012 were $661.2 million and $562.9 million, respectively.
Three large international brokers accounted for approximately 27 percent, 22 percent and 11 percent in 2013 and approximately 26 percent, 21 percent and 12 percent from the TransRe Acquisition Date through December 31, 2012 of gross premiums written in the reinsurance segment.
As of December 31, 2013, Alleghany had long-term compensation plans for parent-level employees and directors. Parent-level, long-term compensation plans to current employees do not include stock options but consist only of restricted stock awards, including restricted stock units and performance share awards. Parent-level, long-term compensation payments to non-employee directors consist of annual awards of restricted stock and restricted stock units.
fair market value, respectively, and $16.3 million, $5.3 million and $5.8 million of cash, respectively, was paid by Alleghany under plans for parent-level employees and directors. As noted above, as of December 31, 2013 and December 31, 2012, all outstanding awards were accounted for under the fair-value-based method of accounting.
In February 2012, Alleghany adopted the 2012 Long-Term Incentive Plan (the “2012 LTIP”), which was approved by Alleghany stockholders in April 2012. Awards under the 2012 LTIP may include, but are not limited to, cash and/or shares of 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 of 1986, as amended, and options not intended to so qualify. Under the 2012 LTIP, the following types of awards were outstanding as of December 31, 2013:
Restricted Share Awards - From time to time, Alleghany has awarded to certain management employees restricted shares or restricted stock units of Common Stock. These awards entitle the participants to a specified maximum amount equal to the value of one share of Common Stock for each restricted share issued to them based on the market value on the grant date. The expense is recognized ratably over the performance period, which can be extended under certain circumstances.
Alleghany has endorsement split-dollar life insurance policies for its parent-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 annual salary at the time of an officer’s death. After retirement, death benefits that inure to the beneficiaries are generally equal to the annual ending salary of the officer at the date of retirement.
These employee retirement plans are not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2013.
The projected benefit obligations of both defined benefit pension plans as of December 31, 2013 and 2012 was $21.6 million and $26.4 million, respectively, and the related fair value of plan assets was $2.4 million and $2.7 million, respectively.
TransRe has an unfunded, noncontributory defined benefit plan and a funded noncontributory defined benefit plan for some of its employees in the U.S. Benefits under TransRe’s defined benefit plans were frozen as of December 31, 2009. As of December 31, 2013 and 2012, the projected benefit obligation was $49.8 million and $55.3 million, respectively, and the related fair value of plan assets was $42.4 million and $47.0 million, respectively.
Selected quarterly financial data for 2013 and 2012 are presented below:
In our opinion, Alleghany Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.