The Company leases office space in San Antonio, Texas for its corporate headquarters and for certain support functions associated with Argonaut Insurance. Other leased headquarters locations for the Company’s operating subsidiaries include offices in Richmond, Virginia (Colony), Rockwood, Pennsylvania (Rockwood), Portland, Oregon (Grocers Insurance), Chicago, Illinois (Select Markets), San Antonio, Texas (Trident), New York, New York (Argonaut Specialty) and Menlo Park, California (Argonaut Insurance) Great Central is headquartered in facilities it owns in Peoria, Illinois. In addition, the Company has entered into other leases in conjunction with its operations at various locations throughout the country. The Company believes that its properties are adequate for its present needs.
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 53. This discussion contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.
For the year ended December 31, 2006, Argonaut Group, Inc. reported net income of $106.0 million, or $3.13 per fully diluted share, compared to $80.5 million or $2.53 per fully diluted share for 2005 and $71.8 million, or $2.33 per fully diluted share for 2004. During the year ended December 31, 2006 growth in gross written premiums was the result of the following factors: (a) the integration of the renewal rights acquisition, in the second quarter of 2005, within the Excess and Surplus Lines segment, (b) the maturation of Argonaut Specialty which began writing business in April of 2005, (c) new business initiatives within Select Markets and (d) organic growth. Also during 2006 the Company managed the run-off of the
The following is a comparison of selected data from the Company’s operations:
The increase in consolidated earned premiums was primarily attributable to growth in premiums written in all years presented. Gross written premiums from new business increased to $512.4 million for the year ended December 31, 2006 compared to $476.8 million and $402.1 million for 2005 and 2004, respectively. The increase in gross written premiums from new business was primarily attributable to growth in the Excess and Surplus Lines and Public Entity segments. Growth in the Excess and Surplus Lines segment was related to the renewal rights acquisition which was executed in April 2005, combined with premium growth within Argonaut Specialty, which also began writing business in the second quarter of 2005. Partially offsetting this growth was a reduction in gross written premiums within the Risk Management segment due to the renewal rights sale effective in the third quarter of 2005.
Consolidated net investment income increased in 2006 as compared to 2005 and 2004 due to higher invested balances resulting from positive cash flows from operations, capital raising initiatives in 2004 and 2005, coupled with higher yields. Total invested assets were $2,514.1 million, $2,173.0 million and $1,783.9 million as of December 31, 2006, 2005 and 2004, respectively.
Consolidated loss reserves were $2,029.2 million, $1,875.4 million and $1,607.5 million as of December 31, 2006, 2005 and 2004, respectively. Management has recorded its best estimates of loss reserves as of December 31, 2006 based on current known facts and circumstances. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development will not occur.
Consolidated underwriting, acquisition and insurance costs were $285.1 million, $262.5 million and $222.8 million for the years ended December 31, 2006, 2005 and 2004, respectively. The improvement in the expense ratio in 2006 as compared to 2005 was primarily the result of higher earned premiums related to the renewal rights acquisition in the Excess and Surplus Lines segment and Argonaut Specialty as both books of business are more reflective of the inforce business. Additionally, included in underwriting expenses for 2005 was a charge of $6.2 million associated with the commutation of a reinsurance contract.
Consolidated interest expense was $13.0 million, $15.0 million and $11.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. Interest expense resulting from the junior subordinated debentures was $12.6 million in 2006, compared to $8.9 million and $3.6 million in 2005 and 2004, respectively. The increase in interest expense on the junior subordinated debentures was due to rising interest rates, coupled with recording a full year of interest expense on the $30.9 million of debentures issued in December 2005. Interest expense for funds withheld under a retroactive reinsurance contract totaled approximately $5.5 million and $6.9 million for the years ended December 31, 2005 and 2004, respectively. The decrease in 2005 was due to the commutation of the related reinsurance contract during the third quarter of 2005. Interest expense for various other funds withheld by the insurance subsidiaries totaled $0.4 million, $0.6 million and $0.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The consolidated provision for income taxes for the year ended December 31, 2006 was $57.0 million. The consolidated provision for income taxes for the year ended December 31, 2005 was $1.0 million, and includes tax expense of $26.1 million offset by the reversal of the remaining deferred tax valuation allowance of $25.1 million. The consolidated benefit for income taxes for the year ended December 31, 2004 was $11.1 million, and includes tax expense of $12.9 million, a reduction of the deferred tax valuation allowance of $24.0 million. During 2004, the Company reduced its liability for accrued taxes by $10.9 million due to the state of California enacting a law providing for a partial tax deduction for certain insurance company dividends received by a company subject to California corporate income tax. This reduction is included in the $12.9 million provision for income taxes for the year ended December 31, 2004. The reduction of the deferred tax valuation allowance in 2005 and 2004 was based on management’s consideration of limited amounts of future income in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes” combined with earnings reported in those years.
Effective in 2006, the Company has modified the classification of two continuing lines programs for purposes of segment reporting. Specifically, the HCC Insurance Holdings, Inc. directors and officers reinsurance program and the state fund program, formerly reported in the Risk Management segment, are now presented as a component of Select Markets. Amounts applicable to prior periods have been reclassified to conform to the presentation followed in 2006. Management believes that this new classification more accurately reflects the on-going business of the operating segments.
Excess and Surplus Lines. Excess and surplus lines insurance carriers focus on risks that the standard market is unwilling or unable to underwrite due to the unique risk characteristics of the insureds or the lack of insurers offering such coverage, which may be caused by physical perils, the nature of the business or the insured’s loss experience. The Company, through Colony and Argonaut Specialty, its two separate platforms, is able to underwrite these risks with more flexible policy terms at unregulated premium rates to the extent the business is underwritten on an excess and surplus lines basis. Colony provides commercial liability, commercial property, products liability and environmental liability coverages to commercial enterprises, including restaurants, artisan contractors, day-care centers and manufacturers, and professional liability coverages for health care providers and other professionals. Colony is approved as a non-admitted insurer in 49 states, the District of Columbia and the U.S. Virgin Islands. Included in Colony’s results of operations is the effect of a renewal rights acquisition that was effective April 1, 2005. Argonaut Specialty, the Company’s second excess and surplus lines platform, began operations in the second quarter of 2005. Argonaut Specialty provides primary general liability, excess/umbrella coverage and property lines of business for risks the admitted market chooses not to underwrite. Argonaut Specialty’s risks are typically larger than Colony’s and it utilizes a smaller distribution platform.
Index to Financial Statements On March 31, 2003, Colony entered into a quota share reinsurance agreement with HCC Insurance Holdings, Inc. (HCC). Under the terms of this agreement, the Company cedes 15% of the gross written premiums from the Excess and Surplus Lines segment, exclusive of Argonaut Specialty and a portion of the renewal rights acquisition, to HCC and HCC will, in turn, assume 15% of the losses. For the year ended December 31, 2006, the Company ceded $74.9 million of gross written premiums, $71.6 million of earned premiums and $41.3 million in losses and loss adjustment expenses. For the year ended December 31, 2005, the Company ceded $66.0 million of gross written premiums, $64.6 million of earned premiums and $35.6 million in losses and loss adjustment expenses. For the year ended December 31, 2004, the Company ceded $62.0 million of gross written premiums, $58.5 million of earned premiums and $35.7 million in losses and loss adjustment expense. The Company receives a ceding commission to offset its acquisition costs related to these premiums. For the years ended December 31, 2006, 2005 and 2004, the Company earned a ceding commission of $14.9 million, $13.2 million and $11.6 million, respectively.
Select Markets. This segment provides property and casualty coverages targeting specific groups of insureds and is underwritten by Great Central, Rockwood and Grocers Insurance. Great Central specializes in property insurance, liability insurance and workers compensation coverage in three broadly defined markets: food and hospitality, religious and other institutions, and specialty retail. Rockwood primarily provides workers compensation insurance for coal mines, other mining business and small commercial accounts. In addition, Rockwood provides supporting general liability, umbrella liability, property, commercial automobile and surety business, for certain of its mining accounts. In December 2003, the Company acquired the right to renew business underwritten by the Grocers Insurance segment of Royal and Sun Alliance USA. Grocers Insurance underwrites property, general liability, and workers compensation to privately owned independent grocers throughout the United States. Also included in the Select Markets segment are policies and programs written through the Company’s Corporate Accounts division.
The following table summarizes the results of operations for the Select Markets segment:
Index to Financial Statements The increase in earned premiums was due to increased premium writing in all years presented. Gross written premiums from renewal business increased to $202.7 million for the year ended December 31, 2006 compared to $178.8 million and $120.7 million for 2005 and 2004, respectively. The increase in gross written premiums from renewal policies in 2006 was primarily attributable to a large account which was first written in 2005 for $18.4 million. The account was renewed in the fourth quarter of 2006 for a 17-month term with premium of $22.6 million. The remaining increase was due to a larger base of expiring premiums subject to renewal. Gross written premiums resulting from new business were $50.6 million, $69.9 million and $90.7 million for the years ended December 31, 2006, 2005 and 2004, respectively. The decline was attributable primarily to a planned shift from small commercial workers compensation accounts to large deductible accounts within the Company’s specialty workers compensation product line, as well as increased competition.
The expense ratio for the year ended December 31, 2006 was 28.0%, compared to 27.7% and 28.3% for 2005 and 2004, respectively. The increase in the expense ratio in 2006 as compared to 2005 was primarily attributable to a reduction in the ceding commission received by the Company for the state fund business. The increase in the expense ratio in 2004 was primarily due to increased start up costs resulting from the Grocers Insurance renewal rights acquisition.
Index to Financial Statements The increase in net investment income for the year ended December 31, 2006 as compared to 2005 and 2004 was primarily attributable to higher invested assets resulting from increased cash flows, coupled with higher yields. Invested assets were $425.3 million, $356.8 million and $302.4 million as of December 31, 2006, 2005 and 2004, respectively.
The following table summarizes the results of operation for the Public Entity segment:
The increase in gross written premiums for the year ended December 31, 2006 as compared to 2005 was primarily the result of an increase in new business written in 2006 as compared to 2005. This increase in new business is a result of both expansions into new states as well as an increase in business from select agents. The decrease in gross written premiums for the year ended December 31, 2005 as compared to 2004 was primarily the result of a decrease in new business written in 2005 as compared to 2004. This decrease in new business during 2005 as compared to 2004 was a reflection of a change in distribution partners in several states, the increasingly competitive market and risk selection. For the year ended December 31, 2006, the Public Entity segment wrote $18.2 million in new business as compared to $7.7 million and $34.2 million for the same periods in 2005 and 2004, respectively. Renewal business written by this segment was $55.5 million for the year ended December 31, 2006, as compared to $59.3 million and $53.7 million for the same periods in 2005 and 2004, respectively. The decrease in earned premiums for the year ended December 31, 2006, as compared to the same period in 2005, was primarily attributable to the higher premium writings in 2004, which were earned during 2005.
The expense ratio for the year ended December 31, 2006 was 31.9% compared to 36.5% and 33.5% for the same periods of 2005 and 2004, respectively. The decrease in the expense ratio in 2006 was primarily related to a regulatory windstorm assessment refund received in 2006 associated with the 2005 hurricanes. The original assessment was included in the expense ratio for the year ended December 31, 2005 contributing to the difference in the expense ratio for the year ended December 31, 2006 as compared to 2005. The increase in the expense ratio in 2005 as compared to 2004 was also primarily related to the same regulatory windstorm assessment in 2005.
For 2005, the Risk Management segment had $1.1 million of favorable development including $6.6 million decrease in other liability reserves resulting from favorable trends on older accident years, offset by $5.5 million of unfavorable development in workers compensation. The unfavorable workers compensation development was driven by $8.0 million of reduced ceded losses from a reinsurance commutation partially offset by favorable development on involuntary pool losses.
Losses and loss adjustment expenses for the year ended 2004 were reduced by $5.3 million for favorable prior accident year development. Favorable development mainly attributable to the 2001, 2002 and 2003 accident years was partially offset by unfavorable development on accident years prior to 2001. Loss reserves for the Risk Management segment were $513.7 million, $580.4 million and $598.7 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Net investment income increased to $33.7 million for the year ended December 31, 2006, compared to $31.9 million and $29.9 million for the years ended December 31, 2005 and 2004, respectively, primarily due to higher invested assets coupled with increased yields. Invested assets as of December 31, 2006 were $766.1 million, compared to $743.4 million as of December 31, 2005 and $657.5 million as of December 31, 2004.
For the year ended December 31, 2006, the Run-off Lines segment incurred an underwriting loss of $9.9 million, compared to underwriting losses of $12.5 million and $0 million for the same periods of 2005 and 2004, respectively (see discussion below).
Argonaut Insurance Company also assumed risk as a reinsurer for a limited period of time, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance Company also reinsured risks on policies written by domestic carriers. Such reinsurance typically provided coverage for limits attaching at a relatively high dollar amount which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance Company are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no apparent medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that claims generated out of this population of claimants may result in incurred losses generally lower than the asbestos claims filed over the past decade and could be below the attachment level of Argonaut Insurance.
The following table represents a reconciliation of total gross and net reserves for the Run-off Lines for each of the years in the three-year period ended December 31, 2006. Amounts in the net column are reduced by reinsurance recoverables:
In 2004, the Company completed its analysis of the adequacy of loss and loss adjustment expense reserves for its Run-off Lines and the review indicated the carried reserves were adequate based on the facts and circumstances then available to the Company.
$138.5 million to $249.1 million. In determining its best estimate, management primarily relied on the report year method, with some weight given to other methods. The report year method relies most heavily on the Company’s historical claims and severity information, whereas other methods rely more heavily on industry information. This method produces an estimate of losses which have been incurred but not yet reported based on projections of future claims and the average severity for those future claims. The severities were calculated based on the Company’s specific data and in management’s opinion best reflect the Company’s liabilities based upon the insurance policies issued. As a result of this reserve analysis, the reserve for incurred but not reported asbestos and environmental claims (net of reinsurance) at December 31, 2006, was $86.5 million compared to $86.0 million and $89.4 million as of December 31, 2005 and 2004, respectively. The reserve for incurred but not reported claims for the remaining Run-off Lines (net of reinsurance) was $4.0 million as of December 31, 2006, compared to $12.0 million and $12.7 million as of December 31, 2005 and 2004, respectively.
The number of claims opened during the three years ended December 31, 2006 were from the following sources:
Included in the gross payments on closed claims in 2004 is a settlement relating to the Western MacArthur litigation. The Company, through its subsidiary Argonaut Insurance, was named in various legal actions filed by Western MacArthur Company, Western Asbestos Company (the MacArthur Companies) and certain other individual claimants. Argonaut Insurance’s involvement in these actions arose from nine construction wrap-up policies with an occurrence limit of $200,000 per policy issued to Western MacArthur Company and Western Asbestos Company, respectively, for liability arising out of work performed on five construction sites in the 1960’s and 1970’s. On April 14, 2004, the Bankruptcy Court presiding over the Chapter 11 Bankruptcy of the MacArthur Companies entered orders giving final approval to settlements reached with all property and casualty insurers of the MacArthur Companies currently in litigation, including Argonaut Insurance. A bankruptcy reorganization plan filed by the MacArthur Companies will be implemented and all existing and future claims against the MacArthur Companies related to asbestos will be channeled solely to a trust. Argonaut Insurance contributed $29.8 million into the bankruptcy trust and received a release from the MacArthur Companies as to any and all existing or future asbestos-related claims, including any claims for extra-contractual relief, arising directly or indirectly out of any alleged coverage under the nine Argonaut Insurance polices at issue. In addition, claimants seeking funds from the trust will be required to execute release and indemnity agreements in favor of Argonaut Insurance as a condition to receiving payment. The Company ceded the majority of its $29.8 million contribution to its reinsurers.
Net cash used by investing activities totaled $292.4 million, $414.7 million and $250.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. Cash was primarily used to acquire fixed maturity and equity investments, offset by cash received from sales, calls and maturities of fixed asset securities and sales of equity securities. The Company received $17.3 million in cash as a result of the sale of a strategic investment during the year ended December 31, 2006. As of December 31, 2006, 2005 and 2004, $213.2 million, $272.6 million and $112.4 million, respectively, of the investment portfolio were invested in short-term, liquid investments.
Net cash provided by financing activities totaled $7.5 million and was primarily the result of cash received through stock options exercises. Net cash provided by financing activities totaled $79.5 million for the year ended December 31, 2005, and was primarily attributable to the Company’s issuance of common stock and junior subordinated debentures. For the year ended December 31, 2004, net cash provided by financing activities totaled $83.8 million, and was primarily attributable to the Company’s issuance of junior subordinated debentures.
Index to Financial Statements Cash dividends paid to preferred shareholders totaled $1.4 million, $2.2 million and $2.5 million for the years ended December 31, 2006, 2005 and 2004, respectively. The decrease in preferred dividends paid was the result of the reduction of preferred shares outstanding (1.0 million shares outstanding at December 31, 2006 compared to 2.4 million shares at December 31, 2005), coupled with a reduction of the dividend rate from 7% in 2005 to 6% in 2006. The reduction in the dividend rate was the result of an improved risk based capital ratio in 2005 and continuing into 2006.
During 2005, Argonaut Group Statutory Trust X (Trust X), a wholly owned subsidiary of the Company, sold 30,000 Floating Rate Capital Securities (the Capital Securities) (liquidation amount $1,000 per Capital Security) in a private sale for $30.0 million. The statutory trust is not consolidated with the Company, as the primary beneficiaries are the investors of the floating rate securities. Trust X used the proceeds from this sale, together with the proceeds from its sale of 928 shares of Floating Rate Common Securities (liquidation amount $1,000 per Common Security) to the Company, to buy a series of Floating Rate Junior Subordinated Debentures due 2035 from the Company. The Debentures have the same payment terms as the Capital Securities.
During 2003, the Company, through a series of statutory trusts, sold $27.0 million of Floating Rate Capital securities (the Capital Securities) (liquidation amount $1,000 per Capital Security) in a series of private sales. In conjunction with the sales of the Capital Securities, the trusts sold $0.8 million of Floating Rate Common Securities to the Company. The trusts used the proceeds from these sales to purchase $27.8 million of Floating Rate Junior Subordinated Debentures (the Debentures) from the Company. The interest rates on the Debentures and the Capital Securities are equal to the 3-Month LIBOR plus a margin of 4.10%, reset quarterly. The interest rates are not to exceed 12.5% prior to the coupon cap date, which is approximately 5 years after the issuance date. The Debentures are unsecured and are subordinate in right of payment to all of the Company’s future senior indebtedness. The Debentures are due 30 years after issuance, but may be redeemed after the five-year anniversary at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest on the date of redemption. The Debentures may be redeemed prior to the five-year anniversary date upon the occurrence of specific events at a price equal to 107.5% to 100.95% plus accrued and unpaid interest to the date of redemption.
The Company’s insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to fund operating expenses. During the three years ended December 31, 2006, the Company’s liquidity generated from operations and investment income were sufficient to meet obligations. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as satisfy its commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
The Company maintains a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard its financial position. The 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.
Credit risk is a major factor of the overall enterprise risk within the Company, and the Company has established policies and procedures to evaluate the Company exposure, particularly with regards to its investment holdings, and its receivable balances from insureds and reinsurers.
Index to Financial Statements The Company controls its credit exposure related to financial instruments by limiting exposure to any one counterparty and mandating minimum credit ratings. The Company utilizes specific criteria to judge the credit quality and liquidity of its investments in addition to a variety of credit rating services to monitor these criteria.
The pension plan measurement date for purposes of the consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which management believes the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2006, the Company used the following assumptions: a discount rate of 5.5% and an expected rate of return on plan assets of 5.5%.
The Company curtailed both its defined benefit pension plan and its non-qualified unfunded supplemental defined benefit plan in February 2004. During 2004, the Company did not incur any pension expense. The Company incurred pension expense of $0.4 million and $0.6 million during the years ended December 31, 2006 and 2005, respectively. The projected pension obligation as of December 31, 2006 was $26.6 million. Based on the current funding status of the pension plan, the effects of the curtailment, and expected changes in pension plan asset values and pension obligations, the Company does not believe any significant funding of the pension plan will be required during the year ended December 31, 2007.
Index to Financial Statements Allan W. Fulkerson. Century Capital Management, LLC (“CCML”), a successor to Century Capital Management, Inc., is the Investment Advisor to two partnerships (Century Capital Partners II, L.P. and CCPIII) that collectively hold a majority ownership interest in Asset Allocation & Management Company, L.L.C. (“AAM”). Allan W. Fulkerson, who is a member of the Company’s Board of Directors, serves as a consultant to CCML. Prior to December 31, 2004, Mr. Fulkerson also served as a director of the general partner of CCPIII. Mr. Fulkerson retains a 7% ownership interest in the general partner of CCPIII. As such, he has an indirect ownership interest in AAM of less than one-half of one percent.
The Company’s estimated contractual obligations and commitments as of December 31, 2006 were as follows:
(3) Claims payments do not have a contractual maturity; exact timing of claims payments cannot be predicted with certainty. The above table estimates timing of claims payments based on historical payment patterns and excludes the benefits of reinsurance recoveries.
The process for estimating the Company’s loss reserves begins with the collection and analysis of claim data. The data collected for actuarial analyses includes reported claims sorted by the year the loss occurred, paid losses, also sorted by year of loss occurrence, and case reserve estimates. The data sets are sorted into homogeneous groupings, exhibiting similar loss and exposure characteristics. The Company primarily uses internal data in the analysis but also considers industry data in developing factors and estimates. The Company analyzes loss reserves on a quarterly and annual basis. The Company also employs independent actuaries to supplement internal analyses, which are considered in deriving management’s best estimate of loss reserves.
The Company has a Run-off Lines segment of general liability loss reserves for asbestos, environmental, and other latent exposures. These latent exposures are typically characterized by extended periods of time between the date the Company first became exposed to a loss, the date on which a claim was reported, and the date on which the claim is resolved. Due to these delays, together with intervening changes in laws and judicial precedent, and lack of appropriate data to estimate loss reserves associated with these exposures, the Company utilizes certain additional methods to estimate these loss reserves which are not generally applied when estimating loss reserves for ongoing lines of business. The Company analyzes its Run-off Lines loss reserves on a quarterly and annual basis. The Company also employs independent actuaries to supplement internal analyses, which are considered in deriving management’s best estimate of Run-off Lines loss reserves.
For short tailed lines of business such as property, loss experience is generally credible 18 to 36 months after the beginning of the accident year. The expected loss ratio method is initially selected and applied to earned premium at the beginning of an accident year. As property losses occur and are reported, and when claims adjusters have sufficient time and information to make specific claims estimates, the BF methods are utilized to supplement the expected loss ratio method. Property losses are generally reported within a short time from the date of loss, and in most instances property claims are settled and paid within a relatively short period of time. Therefore, approximately six months after the accident year has expired, paid and incurred loss ratio methods are given greater weight in the Company’s analyses. In the event there are large claims incurred, the Company will analyze large loss information separately to ensure that the loss reserving methods appropriately recognize the magnitude of these losses in the evaluation of ultimate losses.
For the general liability and automobile liability long tail lines, the starting point for determining ultimate losses is initially the expected loss ratio method, just as it is for short tailed lines. Because the time lag for reporting claims is greater in liability lines of business, facts and information are frequently not complete at the time case reserves are established, and because protracted litigation is sometimes involved creating additional uncertainty in final settlement amounts, case reserves
Workers compensation is a long tailed line of business and also requires a minimum of 60 to 72 months after the beginning of an accident year until the data is deemed fully credible for paid and incurred reserve evaluation methods. Until that time, an expected loss ratio method is utilized for the initial 12 to 18 months of an accident year, followed by paid and incurred BF loss development methodologies. Frequency and severity statistics are also tracked for workers compensation and used to supplement the other actuarial techniques. Loss development for workers compensation spans many years. However, a significant portion of the outstanding reserves correspond to scheduled annuity payments and are not subject to extreme volatility. The portion of reserves that is not scheduled or annuitized is subject to potentially large variations in ultimate loss cost due to the uncertainty of medical cost inflation. Sources of medical cost inflation include increased utilization, new and more expensive medical testing procedures, and increased utilization and cost of prescription drugs.
The Company underwrites environmental and pollution coverages on a limited number of policies and underground storage tanks. The Company establishes loss reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company.
Through its subsidiary, Rockwood, the Company has exposure to claims for black lung disease. Those diagnosed with black lung disease are eligible to receive workers compensation benefits from various federal and state programs. These programs are continually being reviewed by the governing bodies and may be revised without notice in such a way as to increase the level of the Company’s exposure. Rockwood also has exposure to claims from lead paint on general liability policies written for certain public housing authorities from the mid 1980’s to the mid 1990’s. Management has recorded its best estimate of approximately $16.7 million of loss reserves related to these exposures based on the trends and facts currently known.
The following section details reserving considerations and loss and LAE risk factors for the product lines representing most of the Company’s loss reserves. Each risk factor presented will have a different impact on required loss reserves. Also, risk factors can have offsetting or compounding effects on required loss reserves. For example, introduction and approval of a more expensive medical procedure may result in higher estimates for medical inflation costs. But in the workers compensation context, the availability of that same medical procedure may enable workers to return to work more quickly, thereby lowering estimates for indemnity costs for that line of business. As a result, it usually is not possible to identify and measure the impact that a change in one discrete risk factor may have or construct a meaningful sensitivity expectation around it. The Company does not make explicit estimates of the impact on loss reserve estimates for the assumptions related to the risk factors described below.
Loss adjustment expenses used in connection with the Company’s loss reserves are comprised of both allocated and unallocated expenses. Allocated loss adjustment expenses relate to specific claim files. The Company typically combines allocated loss adjustment expenses with losses for purposes of projecting ultimate liabilities, since most estimation methods contemplate inclusion of both. For some types of claims, such as asbestos and environmental claims, allocated loss adjustment expenses consisting primarily of legal costs may be significant, sometimes exceeding the liability of the Company to indemnify claimants for losses. Unallocated loss adjustment expenses are those which are not associated with the handling of any specific claim, and relate to the general administration and handling of claims in the ordinary course of business. Unallocated loss adjustment expenses are calculated as a percentage of unpaid losses for each line of business and are typically less volatile than estimates for losses or allocated loss adjustment expenses.
Major factors contributing to uncertainty in loss reserve estimates for general liability include reporting lags (i.e., the length of time between the event triggering coverage and the actual reporting of the claim), the number of parties involved in the underlying tort action, events triggering coverage that are spread over multiple time periods, the inability to know in advance what actual indemnity costs associated with an individual claim will be, the potential for disputes over whether claims were reasonably foreseeable and intended to be covered at the time the contracts were written, and the potential for mass tort claims and class actions. Generally, claims with a longer reporting lag time are characterized by greater inherent risk of uncertainty.
Many of the Company’s general liability claims require extended time periods to resolve due to delays in reporting, complex coverage issues, and difficulties in assessing claim values and ultimate loss payouts. Some lines require specialized claim handling, such as industrial casualty, general casualty and professional liability exposures and require additional time to resolve. Actuarial methods used to forecast ultimate liabilities in these and other general liability lines are adjusted to take into consideration the uncertainties related to handling claims expected to remain open for an extended period of time.
For asbestos and environmental claims, the Company supplements its traditional loss forecasting methods with additional approaches that attempt to capture the risk characteristics of these insureds and the claimants involved.
Workers compensation is generally considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. Certain payments, such as initial medical treatment or temporary wage replacement for
The Company has a significant portion of its historical workers compensation exposure and loss reserves in California, although the Company has largely discontinued writing new workers compensation exposure in that state. Loss development methods utilize paid and incurred development patterns specific to California to project ultimate losses. Likewise, non-California exposures use a different set of factors to develop estimates of projected ultimate losses. Within a particular geographic region, the Company separates exposures into one of two product classes: one for policies requiring that insureds share in the risk of loss through large deductibles or through premiums which fluctuate based on actual loss experience, and one for policies issued on a guaranteed cost basis. Each class exhibits different loss development characteristics, and the actuarial methods employed to estimate ultimate losses contemplate these variances.
Because commercial multiple peril lines involve both short tail and long tail coverages, the Company gives weight to different methodologies in deriving management’s best estimate of loss reserves based on the coverage being evaluated. Paid and incurred loss development methods are used to forecast property losses. For liability losses, due to the Claims and Book of Business risk factors described in the General Liability section above, the Company uses several loss reserving methods to capture the development characteristics associated with these lines of business. Paid and incurred loss development, paid and incurred Bornhuetter-Ferguson methods, and a loss frequency/severity method are utilized in deriving management’s best estimate of loss reserves. In addition to these approaches, which are used across all commercial multiple peril categories of business, the Company also considers additional analytic measures in deriving its loss reserve estimate for certain product lines with differing characteristics.
Liability claims arising from the Company’s commercial multiple peril exposures are typically not as severe as those arising from other general liability classes of business written by the Company. As a result, the Company captures paid and incurred loss statistics specific to the various industries being targeted.
The Company estimates reserves using a variety of methods, assumptions and data elements. The reserve estimation process includes explicit assumptions about a number of factors in the internal and external environment. Across most lines of business, the most important assumptions are future loss development factors applied to paid or reported losses to date. For most lines, the reported loss development factor is most important. In workers compensation, paid loss development factors are also important. The trend in loss costs is also a key assumption, particularly in the most recent accident years, where loss development factors are less credible.
Recorded gross reserves for property are $37.8 million. Property reserves are for a short tailed line of business and are therefore less volatile than longer tailed lines of business. An expected loss ratio is determined for current business, and the Company is able to determine within 18 to 36 months after the beginning of an accident year whether or not the loss frequency and severity assumptions underlying the expected loss ratio were appropriate. The Company is able to respond more quickly to trends in loss frequency and severity for the Property line of business, and adjust loss reserves accordingly. Because ultimate Property loss values are more easily quantified within 18 to 36 months after the beginning of an accident year, the range of possible loss outcomes is narrower than the range for casualty lines, and the Company is less susceptible to reserve volatility resulting from changes in key assumptions.
Recorded gross reserves for general liability are $942.4 million, with approximately one-fourth of that amount related to run-off asbestos, environmental, and other latent exposures. For general liability losses relating to ongoing operations, reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns for general liability losses deriving from continuing operations. If the reported loss development patterns change by 10%, a change that the Company has experienced in the past and which management considers possible, the estimated net reserve could change by $40 million, in either direction.
Index to Financial Statements Recorded gross reserves for auto liability are $127.6 million across all lines, almost entirely Commercial Lines. Commercial auto liability reserves are shorter-tailed than other lines of business (such as workers compensation) and, therefore, less volatile. However, the size of the reserve base means that future changes in estimate could be material to the Company’s results of operations in any given period. A key assumption for Commercial Lines auto liability is the annual loss cost trend, particularly the severity trend component of loss costs. A review of Insurance Services Office data suggests that annual growth in industry severity since 1999 has varied from +1% to +6%. A 3 point change in assumed annual severity is within the range of historical experience for the industry and for the Company, and which management considers possible. A 3 point change in assumed annual severity could change the estimated net reserve by $20 million, in either direction.
A number of factors affect the variability of estimates for asbestos and environmental reserves including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with
After reviewing the output from various loss reserving methodologies, the Company selects a point estimate of reserves that represents management’s best estimate. Management believes that the aggregate loss reserves at December 31, 2006 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. As of December 31, 2006, the Company recorded gross loss reserves of $2,029.2 million, and loss reserves net of reinsurance of $1,530.4 million. Although a point estimate of reserves is selected for inclusion in the Company’s financial reports, it is unlikely that the final amount paid will equal that point estimate. In order to provide an indication of the variability in loss reserve estimates, the Company develops reserve ranges by applying varying favorable and unfavorable assumptions to loss reserving methods used to derive point estimates.
The Company estimates its range of reserves, net of reinsurance, at $1,416.8 million to $1,701.4 million. In determining this range, loss reserve analyses were performed for each of its major operating segments, comprising both ongoing operations and runoff businesses. As discussed in the Loss Reserve Estimation Methods section, various methodologies and assumptions were utilized. The high and low end estimates are developed by making reasonable changes to specific assumptions and weightings of loss reserve methodologies used to estimate IBNR. High and low end loss outcomes developed for each major business segment are summed together to derive the range. Management believes the variations applied result in a range that represents a reasonably possible lowest to highest outcome.
This approach may result in a different range than might be derived from other approaches, since the Company does not attempt to estimate covariance effects which may occur because its lines of business and the events driving ultimate losses may not be correlated. Nor does the Company’s estimated range recognize sources of unknown or unanticipated correlated events such as potential sources of liability not anticipated at the time coverage was afforded, such as asbestos. These factors in combination with other events which may not be contemplated by management in developing its range may cause reserves to develop either more or less favorably than indicated by assumptions that management considers reasonable. This means that the range of reserve values does not represent the range of all possible favorable or unfavorable reserve outcomes, and actual ultimate paid losses may fall outside this range. No one risk factor has been isolated for the purpose of performing a sensitivity or variability analysis on that particular risk factor. Rather, management estimates a range based upon the estimation methods involved.
In establishing its best estimate for reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts and the legislatures in the recent past and the possibility of similar interpretations in the future, particularly with regard to asbestos and environmental claims, additional loss reserves may develop in future periods. These potential increases cannot be reasonably estimated at the present time. Any increases could have an adverse impact on future operating results, liquidity, risk-based capital ratios and the ratings assigned to the insurance subsidiaries by the nationally recognized insurance rating agencies. However, approximately 95 percent of the Company’s loss reserves are for long tail exposures. Losses for these exposures are generally paid over several years subsequent to changes in loss reserve estimates. As a result, loss reserve changes for long tail lines do not generally impact liquidity in the period of the change.
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. At the end of 2002, a valuation allowance of $71.9 million was established by the Company against the deferred tax asset. During 2004, the valuation allowance was reduced by $24.0 million. During 2005, the valuation allowance was reduced by $25.1 million, resulting in the valuation allowance being fully recovered.
Goodwill. Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. With the restructuring of the Risk Management segment during 2005, the Company reallocated the goodwill previously assigned to this segment in accordance with Statement of Financial Accounting Standard No. 142 “Goodwill and Other Intangibles.” As of December 31, 2006, the Company has $68.3 million of goodwill allocated to the Excess and Surplus Lines segment, $37.1 million assigned to the Select Markets segment and $0.9 million of goodwill allocated to the Public Entity segment. As required by SFAS No. 142, the Company completed its annual test of goodwill for impairment as of September 30, 2006 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, requires a write-down of goodwill for that reporting unit. In evaluating whether impairment exists in certain reporting units, management also considers the fair value in excess of the carrying value for certain assets.
Share-based Payments. In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payments,” which supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and required companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options, non-vested stock grants and stock issued under the employee stock plans. Prior to adopting SFAS 123(R), the Company accounted for stock based compensation under APB Opinion No. 25, recognizing compensation expense only when the fair market value on the measurement date was greater than the strike price of grant. The Company adopted SFAS 123(R) using the modified prospective basis on January 1, 2006. As the Company had various share-based payment plans that were previously subjected to variable accounting under FASB FIN No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” the adoption of SFAS No. 123(R) did not have a material impact on the Company’s results from operations.