Argonaut Group is a national specialty underwriter, focusing on property-casualty lines of insurance. During 2002, the Company continued the strategy it began in 2001 of diversifying its product lines and expanding geographically. For the year ended December 31, 2000, specialty workers' compensation premiums accounted for approximately 78% of gross written premiums. For the year ended December 31, 2002, specialty workers' compensation premiums had declined to approximately 32% of gross written premiums, whereas excess and surplus lines and specialty commercial accounted for 41% and 21% of gross written premiums, respectively. The Company has continued to expand geographically. For the year ended December 31, 2000, approximately 50% of total direct written premiums were concentrated in four states (California, Pennsylvania, Texas and Illinois.) For the year ended December 31, 2002, approximately 50% of direct written premiums were concentrated in six states (California, Pennsylvania, Texas, Florida, Illinois and Maryland.)
On August 23, 2001, pursuant to an Agreement and Plan of Merger and Assignment and Assumption Agreement dated May 7, 2001 and August 15, 2001 respectively, Argonaut Group acquired all of the outstanding stock of Front Royal, Inc. ("Front Royal"). Front Royal is a holding company for specialty insurance underwriters with particular expertise in excess and surplus lines and workers' compensation for targeted types of businesses. Its principal subsidiaries are Colony Insurance Group ("Colony") and Rockwood Insurance Group ("Rockwood"). Argonaut Group paid approximately $168 million in cash for all the issued and outstanding stock of Front Royal. Operating results from the Front Royal subsidiaries are included in the consolidated statement of income from the date of acquisition.
The following is a comparison of selected data from the Company's operations:
Consolidated gross written and earned premiums increased in 2002 due to the inclusion of Colony and Rockwood for the full year period as compared to the four-month period since acquisition in 2001, combined with rate increases and new business in all segments. Colony and Rockwood contributed approximately $335.7 million of gross written premiums and $220.6 million of earned premiums during 2002, compared to $71.1 million in gross written premiums and $57.2 million of earned premiums during 2001.
Consolidated expense ratios were 38.2%, 44.9% and 73.4% for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in the expense ratio resulted from the economies of scale realized from the increase in gross written premiums, primarily driven by the excess and surplus lines and specialty commercial segments.
As of December 31, 2002, the Company had a net deferred tax asset of $91.9 million before valuation allowance, consisting of net operating loss carryforwards and temporary differences between taxable income determined in accordance with accounting principles generally accepted in the United States ("GAAP") and the current tax laws. The provision for income taxes for the year ended December 31, 2002, includes a valuation allowance for the deferred tax asset of $71.9 million. The valuation allowance was recorded by management based on its interpretation of the provisions of Statement of Financial Accounting Standards No. 109. The deferred tax asset, net of the valuation allowance, is $20.0 million as of December 31, 2002 (see discussion on page 35.)
For the year ended December 31, 2002, the excess and surplus lines segment reported segment profit of $18.5 million and a combined ratio of 94.7%, compared to segment profit of $5.5 million and a combined ratio of 94.0% for the same period ended 2001.
The increase in investment income was the result a complete twelve-month period being included for 2002, as compared to four months included in 2001, coupled with positive cash flow that increased invested assets.
The following table summarizes the specialty commercial segment results of operations for the years ended December 31, 2002, 2001 and 2000. Rockwood was acquired by the Company effective September 1, 2001, and its results from operations are included from this date.
The increase in gross written premiums resulted primarily from the inclusion of Rockwood for the entire twelve-month period in 2002, as compared to the four-month period in 2001, combined with rate increases and new business. For the year ended December 31, 2002, Rockwood's renewal premiums approximated $59.9 million, which equated to a retention rate of 91.6%. The renewal premiums included rate increases of 10% over the prior year. Rockwood also reported gross written premiums of approximately $16.4 million related to new business for the year ended December 31, 2002. Argonaut Great Central generated renewal premiums of approximately $36.5 million, with average rate increases of 15%. Argonaut Great Central's retention rate was 85.6% for the year ended 2002. New business written by Argonaut Great Central totaled $13.7 million for the period ended December 31, 2002. The increase in gross written premiums in 2001 as compared to 2000 was the result of Rockwood contributing $21.7 million in premiums combined with Argonaut Great Central implementing average rate increases of 20.9%.
The specialty commercial segment's loss ratio for the year ended December 31, 2002 was 70.9%, compared to 73.8% and 94.8% for 2001 and 2000, respectively. Argonaut Great Central recorded total losses and loss adjustment expense of $24.4 million for the year ended December 31, 2002, compared to $26.3 million and $28.2 million for 2001 and 2000, respectively. The implementation of more stringent underwriting standards and claims initiatives at Argonaut Great Central, combined with pricing actions and geographical and product diversification, have resulted in the improvement in the loss ratio to 67.5% for the year ended December 31, 2002, compared to 77.4% and 94.8% for 2001 and 2000, respectively. Rockwood reported losses and loss adjustment expenses of $50.3 million for the year ended December 31, 2002, compared to $13.9 million for the period since acquisition ending December 31, 2001. Rockwood's loss ratio increased from 68.3% for the four months ended December 31, 2001 to 72.7% for the twelve months ended December 31, 2002. The increase in the loss ratio for 2002 was primarily the result of development in the workers' compensation line related to higher than anticipated indemnity and medical exposure for accident years 2000 and 2001. Partially offsetting the workers' compensation increases was favorable development on general liability and other lines of business. The specialty commercial segment reported loss reserves of $172.2 million, $156.9 million and $51.1 million as of December 31, 2002, 2001 and 2000, respectively.
The following table summarizes the results of operations for the specialty workers' compensation segment:
Gross earned premiums increased $9.3 million on core retained business in 2002 versus 2001. The decline in net premiums earned in 2002 as compared to 2001 was primarily the result of increased ceded premiums. For policies incepting subsequent to September 30, 2001, reinsurance coverage was purchased which decreased the specialty workers' compensation loss retention from $1 million to $250,000 per occurrence. The effect of this treaty along with significantly higher reinsurance rates obtained for the January 1, 2002 renewal reinsurance treaties, covering losses incurred above $1 million, resulted in significantly increased ceded premiums in 2002. The increase in rates for reinsurance treaties incepting on January 1, 2002 was primarily driven by the terrorist attacks of September 11, 2001. The increase in earned premiums in 2001 as compared to 2000 was primarily the result of additional earned premiums on retrospectively rated policies.
Losses and loss adjustment expenses for the year ended December 31, 2002 resulted in a loss ratio of 86.6%, compared to 102.2% and 219.2% for 2001 and 2000, respectively. The Company began to re-underwrite the specialty workers' compensation book of business in the second half of 2000 in an effort to obtain rate increases and improve risk selection. Losses and loss adjustment expenses reported in 2002 include losses of approximately $13.0 million attributable to a single policy from a program that incepted three years ago. The Company no longer insures this risk effective January, 2003.
Net losses and loss adjustment expenses reported in 2001 and 2000 include reserve strengthening of $7.0 million and $134.0 million, respectively. Loss reserves for this segment were $630.0 million, $622.2 million and $622.9 million as of December 31, 2002, 2001 and 2000, respectively. The reserve strengthening in 2001 and 2000 was primarily the result of deteriorating results for the Company's California business. A 1996 California legal ruling adverse to the industry referred to as the Minnear Decision was a primary driver increasing claims severity. This decision gave a worker's physician control in determining all aspects of a worker's medical condition which significantly reduced an insurer's ability to manage the claim. The recognition of levels of claims severity escalation began emerging in 1999 and continued into 2000. As a result, the Company, as well as the workers' compensation industry in California, reported deteriorating results. Recognition of the full effect of this legal ruling was delayed due to the nature of workers' compensation injuries, the subjective nature of the system which administers the claims and the amount of time from the accident occurring and the claimant passing through the system. The claims experience related to increased severities could be an indication of a trend in the state of California and other states, and increase ultimate losses for future accident years. Reserves for losses and loss adjustment expenses are based on actuarial methods that include various techniques and include industry data as well as company specific data. An independent actuarial firm reviews the Company's specialty workers' compensation reserves quarterly.
The expense ratio for the specialty workers' compensation segment was 47.6% for the year ended December 31, 2002, compared to 42.9% and 75.8% for 2001 and 2000, respectively. Lower earned premiums in 2002 due to higher ceded premiums are causing the expense ratio increase in 2002. In addition, commissions, premiums taxes, licenses and bureau fees are a function of written premiums as opposed to earned premiums. These expenses increased for 2002 due to the increase in written premiums as discussed above. During 2002, this segment deferred $13.0 million of acquisition costs. Acquisition costs were not deferred during 2001. The decrease in underwriting expense in 2001 as compared to 2000 was primarily the result of cost saving initiatives implemented in the fourth quarter of 2000, focusing on reducing compensation and outside service expenses. Additionally, during 2000, deferred acquisition costs of approximately $1.4 million were written off.
In the first half of 2003, Argonaut Insurance Company will reorganize its operations to concentrate on casualty risk management solutions for upper-middle market accounts, which have been the historical core of its business. With the elimination of non-strategic businesses, Argonaut Insurance Company will reduce its workforce by 15 percent over the first and second quarters of 2003 and will incur a reorganization charge of approximately $3 million in the first half of 2003. The reorganization will also have the effect of reducing operating expenses in the latter half of 2003 and in future years. In its refocused configuration, Argonaut Insurance Company is expected to produce less than 20 percent of the Group's gross written premium on a prospective basis.
For the year ended December 31, 2002, the public entity segment reported a segment profit of $0.3 million, compared to $0.1 million for 2001. The segment combined ratio was comparable between the two years.
Run-off lines. The Company has discontinued active underwriting of certain lines of business. The Company is still obligated to pay losses incurred on these lines which include general liability and medical malpractice policies written in past years. The lines currently in run-off are characterized by long elapsed periods between the occurrence of a claim and any ultimate payment to resolve the claim. The Company utilizes a specialized staff dedicated to administer and settle these claims.
For the year ended December 31, 2002, the run-off segment recorded a segment loss of $67.8 million. The segment loss was the result of reserve strengthening of approximately $59.8 million discussed below, plus an increase in the allowance for doubtful accounts related to reinsurance recoverable balances of approximately $7.2 million.
Corporate policy beginning in 1985 was to exclude asbestos coverage on all general liability policies. During the third quarter of 2002, management identified claims associated with certain general liability policies issued through one office from 1985 to the early 1990's which did not exclude absolute asbestos coverage. The Company strengthened its loss reserves by $7.0 million in the third quarter for these claims. The Company reviewed policy files issued during this period for additional exposures and management believes the policies written were limited to this specific time frame and location.
The following table represents the components of gross loss reserves for the run-off lines for each of the years in the three-year period ended December 31, 2002.
The nature of insurance is that cash collected on premiums written is invested, interest and dividends are earned thereon, and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of the Company's loss and loss expenses are paid out over more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payrolls and general overhead expenses.
For the year ended December 31, 2002, net cash provided by operating activities was $116.8 million as compared with net cash used of $37.4 million and $94.1 million in 2001 and 2000, respectively. The cash flow provided by operations in 2002 was primarily the result of an increase in gross written premiums. The cash flow used for operations in 2001 was primarily attributable to claims payments for run-off lines. The cash flow used for operations in 2000 was the result of claims payments on run-off lines combined with payments on claims incurred on workers' compensation policies written in prior years.
The Company invests excess cash in a variety of investment securities. As of December 31, 2002, the Company's investment portfolio consisted of 75.7% fixed maturities, 20.1% equities and 4.8% other, compared to 67.6% fixed maturities, 28.3% equities and 4.1% other for the same period in 2001. The Company classifies its investment portfolio as available for sale; therefore all investments are reported at fair market value, with unrealized gains and losses being reported as a component of shareholders' equity. The current downturn in the investment markets, particularly the equities market, has resulted in shareholder's equity being reduced by approximately $20.8 million, net of tax, due to the reduction of unrealized gains. As of December 31, 2002, the Company held common stock in Curtiss-Wright Corp. with a fair market value of $40.8 million, or approximately 12.4% of total shareholders' equity. As of December 31, 2001, the Company had no investment in any one investment exceeding 10% of shareholder's equity.
The Company maintains a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard its financial position. Across all sectors, reinsurance rates have substantially increased. The additional reinsurance costs of the Company's program, to the extent not passed on to customers through increased rates, may have a negative impact on liquidity.
A trust has also been established to secure payments owed to the Company from the reinsurer. The Company is the sole beneficiary of this trust. Securities of approximately $84 million were transferred to the trust as of December 31, 2002, and securities of approximately $16 million were transferred to the trust in February 2003 to secure such payments.
Concerns over terrorist activity have both curtailed the availability of reinsurance for terrorism related risks and increased the cost of obtaining such reinsurance where it is still available. The effect of this industry-wide phenomenon on Argonaut Group's insurance subsidiaries varies by line of business, but reinsurance coverage for terrorist acts involving nuclear, biological and chemical agents is no longer available or cost prohibitive in some instances, thus preventing ceding of these risks through reinsurance. Argonaut Group's insurance subsidiaries have reviewed their accounts for potential exposure to these risks as well as other risks in order to make appropriate decisions on policy exclusions, pricing and renewals, although laws in many states (and particularly those relating to workers' compensation insurance) place limits on the ability of insurers to effectively address these risks by contract.
In addition to its investment portfolio, the Company's subsidiaries own real property for use as home office facilities for Argonaut Insurance Company and Argonaut Great Central, as well as three commercial properties in California. These real properties are included in "Other Assets" valued at $3.9 million, which is their original cost less accumulated depreciation. The current fair market value of the three commercial properties is estimated at $88 million, based on appraisals completed in November 2001. Subsequent to December 31, 2002, the Company closed the sale of a parcel of undeveloped property (see discussion on page 31.)
Various state insurance laws restrict the amount that may be transferred to the Company from its subsidiaries in the form of dividends without the prior approval of regulatory authorities. In addition, that portion of the Company's net equity which results from the difference between statutory insurance accounting practices and generally accepted accounting principals would not be available for dividends. During 2002, dividends of $11.5 million were paid to the Company by Argonaut Insurance Company. Argonaut Insurance Company is the immediate subsidiary of the Company and is regulated by the California Insurance Code. Under California Insurance regulations, Argonaut Insurance Company will be able to pay dividends in 2003 up to $25.8 million. Based on Argonaut Insurance Company's RBC ratio at December 31, 2002, the California Department of Insurance may require prior approval of any dividends.
In addition, regulators and rating agencies utilize a risk-based capital test designed to measure the acceptable amounts of capital and surplus an insurer should maintain, based on specific inherent risks of each insurer. Insurers failing to meet this benchmark level may be subject to scrutiny by the insurer's domiciliary insurance department and potentially result in rehabilitation or liquidation. As of December 31, 2002, Argonaut Insurance Company's RBC ratio was within the Company Action Level Event. At this level, the regulated insurer is required to submit a Comprehensive Plan of Action to the regulatory body detailing the steps it is taking to raise the RBC ratio above the minimum specified by statute. The plan, to be submitted to the California Department of Insurance, must contain the following:
On March 31, 2003, the Company sold approximately 2.4 million shares of Series A Mandatory Convertible Preferred Stock. The preferred shares were sold through a private placement to a group of investors led by HCC Insurance Holdings, Inc. The Company received gross proceeds of $29.4 million as a result of this sale. The proceeds were used to increase the statutory surplus and RBC of Argonaut Insurance Company. The preferred shares are convertible into common stock at the option of the holder at an initial conversion price of $12.00. Any outstanding preferred shares will automatically convert into common shares on the tenth anniversary of the issuance. The preferred shares will initially pay a 7 percent dividend on a quarterly basis. The dividend rate is subject to certain adjustments based upon the Company's A.M. Best rating and Risk Based Capital level. The holders of the preferred shares will be entitled to vote on an as-converted basis on all matters submitted for the vote of the Argonaut Group common shareholders. Additionally, under the terms of the private placement, the Company has agreed not to pay dividends to common shareholders for a period of two years.
The capital contributed to Argonaut Insurance Company during the first quarter of 2003, if contributed prior to December 31, 2002, would have increased its RBC over the Company Action Level. It is the Company's expectation that profits generated during 2003 and/or other capital raising initiatives will be sufficient to maintain Argonaut Insurance Company's RBC ratio above the Company Action Level.
The Company's current investment strategy is to invest in callable U.S. Agency securities and minimize exposure to the equity market. Management believes this strategy will result in above average short term yields while protecting the portfolio from rising interest rates. As of December 31, 2002, investment mix of the pension portfolio was 92% U.S Government agencies, 6% short term investments, and 2% preferred stock. Fair market value of the investment portfolio as of December 31, 2002 was $36.0 million and included net unrealized losses of $0.8 million.
Total pension expense for the year ended December 31, 2002 was approximately $1.0 million. As of December 31, 2002, the Company has a prepaid pension asset of approximately $4.1 million. The estimated pension liability as of December 31, 2002 was $34.7 million (vested and non-vested participants.) Based on the current funding status of the pension plan, the expected changes in pension plan asset values and pension obligations in 2003, the Company does not believe any significant funding of the pension plans will be required during the year ended December 31, 2003.
The Company does not have any off-balance sheet arrangements or financing activities with special-purpose entities (SPEs).
The discussion of the adoption and pending adoption of recently issued accounting policies is included in "Note 1 - Business and Significant Accounting Policies" in the Notes to the Consolidated Financial Statements, included in Item 8 "Financial Statements and Supplementary Data" on page 36.
Inconsistent judicial decisions and legislative actions continue to broaden liability and scope of policy coverage and to increase the severity of claim payments. As a result, the uncertainties inherent in estimating the ultimate claim costs on the basis of past claims costs have been heightened, further complicating the already complex loss reserving process. Final claim payments, however, may differ from the established reserves, particularly when these payments may not occur for several years. Any adjustments to reserves are reflected in the results for the year during which the adjustments are made.
Investments. The Company's investment portfolio is classified as available-for-sale. Accordingly, the Company carries the investment portfolio on its balance sheet at estimated fair value. The Company measures the fair value of the investments based upon quoted market prices. Unrealized appreciation or depreciation of investments carried at market value is excluded from net income and credited or charged, net of applicable deferred income taxes, directly to a separate component of shareholders' equity. The change in unrealized appreciation or depreciation during the year is reported as a component of other comprehensive income (loss).
Realization of deferred tax assets is dependent upon the Company's generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in the carryback period, generally two years. Due to the cumulative loss position of the Company over the past three years, management established a valuation allowance of $71.9 million against the deferred tax asset. Though the Company believes the deferred tax asset will be fully utilized through future net income, the valuation allowance was established based on the Company's interpretation of SFAS No. 109, particularly due to the cumulative loss position noted above and SFAS No. 109's guidance related to the facts and circumstances in such a situation. If future taxable income is not sufficient to recover the net deferred tax assets as of December 31, 2002, the maximum charge to provision for income taxes will be $20.0 million. If the Company generates sufficient future taxable income to fully utilize the deferred tax assets as of December 31, 2002, the maximum benefit for income taxes will be $91.9 million.
Goodwill. Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. As required by SFAS No. 142, the Company assigned goodwill to its reporting units. As required by SFAS No. 142, the Company completed the transitional goodwill impairment test required by SFAS No. 142 in the second quarter of 2002 and determined that there was no indication of goodwill impairment. Additionally, the Company tested goodwill for impairment as of September 30, 2002 and determined that no impairment of goodwill was indicated. Annually, the Company will perform an impairment of goodwill test. If impairment indicators exist between the annual testing periods, management will perform an impairment of goodwill test to determine if the fair value of the reporting unit is below the carrying value and therefore, require a write-down of goodwill for that reporting segment. In evaluating whether impairment exists in the certain reporting units, management also considers the fair value in excess of the carrying value for certain assets.