(1) On April 26, 2012, we acquired BKI. On March 6, 2012, we acquired TransRe. We sold Darwin on October 20, 2008. Darwin has been reclassified as discontinued operations for the year ended 2008 and discontinued operations, net of minority interest expense, includes the gain on disposition in 2008.
On March 6, 2012, or the “Acquisition Date,” pursuant to an Agreement and Plan of Merger, or the “Merger Agreement,” among Alleghany, our wholly-owned subsidiary, Shoreline Merger Sub, LLC (subsequently converted into a corporation), or “Merger Sub,” and Transatlantic Holdings, Inc., or “Old TransRe,” Old TransRe was merged with and into Merger Sub, or the “merger.” As a result of the merger, Merger Sub was renamed “Transatlantic Holdings, Inc.,” and Old TransRe became our wholly-owned subsidiary. Pursuant to the terms of the Merger Agreement, former stockholders of Old TransRe were entitled to receive, in exchange for each share of Old TransRe common stock held, either shares of our common stock or cash consideration with a value equal to approximately $61.14. On the Acquisition Date, we paid to the former stockholders of Old TransRe total consideration of approximately $3.5 billion, consisting of cash consideration of $816.0 million and stock consideration of 8,360,959 shares of our common stock. Our reinsurance operations began immediately following the merger. See Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on the merger.
Our primary sources of revenues and earnings are our reinsurance and insurance operations and investments. We also seek out strategic investments and conduct other activities at the parent level. Strategic investments currently include, among others, an approximately 33 percent stake in Homesite, a national, full-service, mono-line provider of homeowners insurance, and an approximately 38 percent stake in ORX, a regional gas and oil exploration and production company. Primarily through our wholly-owned subsidiary, Alleghany Capital Partners, we manage, source, execute, and monitor our private equity investments. On April 26, 2012, our majority-owned subsidiary Bourn & Koch acquired BKI, a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois. We own and manage land in the Sacramento, California region through our subsidiary Alleghany Properties.
As of December 31, 2012, Alleghany had total assets of $22.8 billion and total stockholders’ equity of $6.4 billion. As of December 31, 2012, we had consolidated total investments of approximately $18.3 billion, of which $16.0 billion was invested in debt securities, $1.4 billion was invested in equity securities, $0.5 billion was invested in other invested assets, and $0.4 billion was invested in short-term investments.
Catastrophe losses, or their absence, can have a significant impact on our results. For example, pre-tax catastrophe losses, net of reinsurance and reinstatement premiums, were $448.7 million in 2012, $74.3 million in 2011 and $31.0 million in 2010. Catastrophe losses in 2012 include a $412.0 million loss from Sandy, which caused widespread property damage and flooding to large areas of the East Coast and northeastern United States in October 2012. Our recorded loss for Sandy is based on an analysis of reported claims, an underwriting review of in-force contracts, estimates of losses resulting from wind and other perils, including storm surge and flooding to the extent covered by applicable policies, and other factors requiring considerable judgment. The ultimate loss from Sandy may be materially different from our estimate due to the size and complexity of the event and the preliminary nature of the information available to prepare the estimate.
As part of their overall risk and capacity management strategy, our reinsurance and insurance operating units take certain measures to mitigate the impact of catastrophe events through various means including considering catastrophe risks in their underwriting and pricing decisions, purchasing reinsurance, monitoring and modeling accumulated exposures, and managing exposure in key geographic zones and product lines that are prone to catastrophic events.
The reinsurance programs purchased by our reinsurance and insurance operating units are generally subject to annual renewal. Market conditions beyond the control of our reinsurance and insurance operating units determine the availability and cost of the reinsurance protection they purchase, which may affect the level of business written and thus their profitability.
The following table summarizes our consolidated revenues, costs and expenses and earnings (in millions).
Exxon Mobil Corporation, or “Exxon Mobil,” common stock in January 2012. Other income in 2012 included a $23.5 million gain from a TransRe legal settlement, of a dispute (see “Legal Proceedings” set forth in Part I, Item 3 of this Form 10-K for additional discussion of this settlement).
The effective tax rate was 2.4 percent for 2012, 24.9 percent for 2011 and 28.4 percent for 2010. 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 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 lower effective tax rate in 2011 primarily reflects the impact of higher dividends received deductions and lower pre-tax earnings in 2011, partially offset by the absence of a foreign tax benefit which was significant in 2010.
The following tables summarize results of our reinsurance and insurance segments.
Earnings before income taxes for our insurance segment in 2011 decreased from 2010, primarily reflecting higher loss and LAE, lower net premiums earned, lower net investment income, and lower net realized capital gains, partially offset by lower OTTI losses. The increase in loss and LAE primarily reflects a $28.7 million increase in PCC’s prior year reserves and higher catastrophe and other large property losses at RSUI in the 2011 period, partially offset by a higher net release of prior year casualty reserves by RSUI. The decrease in net
premiums earned reflects the impact of continuing competition at CATA, as well as a reduction in net premiums written in certain specialty classes of business by CATA. The decrease in net investment income is due primarily to the impact of negative cash flow at PCC and dividends paid to Alleghany by RSUI and CATA, partially offset by higher dividend income. In addition, the decrease in net investment income in 2011 from 2010 reflects the absence of equity-method partnership income in 2011, as such partnerships were dissolved in the 2010 third quarter.
The reinsurance segment is comprised of TransRe’s property and casualty operations. The underwriting results of the reinsurance segment are presented below, commencing on the Acquisition Date. For a more detailed description of our reinsurance segment, see Part I, Item 1, “Business-Segment Information- Reinsurance Segment” of this Form 10-K.
(3) Net loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.
(4) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.
For both the property and the casualty & other lines of business, the expense ratio for 2012 was favorably impacted as a result of applying the acquisition method of accounting for the merger because deferred acquisition costs were written off at the Acquisition Date. We expect that the expense ratio in subsequent years will increase when all unearned premiums as of the Acquisition Date are fully earned. Excluding the impact of the application of the acquisition method of accounting, the expense ratio for the reinsurance segment was estimated to be approximately 29 percent for 2012.
Property. For 2012, TransRe’s property underwriting profit was $143.4 million, primarily reflecting the favorable impact of the application of the acquisition method of accounting on the expense ratio, partially offset by significant catastrophe losses related to Sandy in October 2012. For 2012, catastrophe losses, net of reinsurance and reinstatement premiums, were $226.9 million, all of which related to Sandy. The $226.9 million is comprised of $252.2 million of net loss and LAE, partially offset by $25.3 million of reinstatement premium. TransRe’s property underwriting profit for 2012 includes $56.6 million of favorable development from prior accident years on loss and LAE reserves acquired.
(1) 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”).
(2) Net loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.
(3) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.
(4) The sum of the loss ratio and expense ratio, all as determined in accordance with GAAP, representing the percentage of each premium dollar an insurance company has to spend on net loss and LAE, and commission, brokerage and other underwriting expenses.
The increase in net loss and LAE in 2012 from 2011 primarily reflects higher catastrophe losses and the impact of an increase in net premiums earned, and, to a lesser extent, slightly lower levels of prior year casualty reserve releases. The increase in loss and LAE in 2011 from 2010 primarily reflects the impact of higher catastrophe and other large property losses, partially offset by the impact of higher releases of prior accident year casualty reserves in 2011.
Catastrophe losses, net of reinsurance and reinstatement premiums, were $197.9 million in 2012, $74.3 million in 2011 and $31.0 million in 2010. Catastrophe losses in 2012 include $161.2 million of net losses, including reinstatement premiums, from Sandy in October 2012. Catastrophe losses in 2012 also include losses from severe weather earlier in 2012, as well as adverse development from prior year catastrophes, including a $9.7 million loss recorded in the second quarter of 2012 related to Hurricane Ike in 2008. 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 United States in August 2011. Catastrophe losses in 2011 also include assumed catastrophe losses from international insurance carriers. 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. Catastrophe losses in 2010 include increases in prior accident year property loss reserves of $5.3 million related to 2008 third quarter hurricanes and $11.0 million related to 2005 third quarter hurricanes.
The decrease in RSUI’s underwriting profit in 2012 from 2011 primarily reflects an increase in loss and LAE, partially offset by an increase in net premiums earned. The decrease in RSUI’s underwriting profit in 2011 from 2010 primarily reflects an increase in loss and LAE.
RSUI reinsures its property lines of business through a program consisting of surplus share treaties, facultative placements, per risk coverage, and catastrophe excess of loss treaties. RSUI’s catastrophe reinsurance program (which covers catastrophe risks including, among others, windstorms and earthquakes) and per risk reinsurance program run on an annual basis from May 1 to the following April 30 and will expire on April 30, 2013.
CATA. Gross premiums written increased by 5.1 percent in 2012 from 2011, primarily reflecting growth in CATA’s property and casualty lines of business, and, to a lesser extent, growth in CATA’s surety business. Net premiums earned decreased in the 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 2012 from 2011 primarily reflects the impact of prior year development. The decrease in loss and LAE in 2011 from 2010 primarily reflects the impact of lower net premiums earned, partially offset by the impact of a net reserve increase of prior accident year loss reserves in 2011 compared with a net reserve release of prior accident year loss reserves in 2010 (as further described below).
The $28.7 million increase of prior accident year workers’ compensation loss and LAE reserves recorded in 2011 include $14.2 million related to an unanticipated increase in medical claims emergence and the absence of anticipated favorable indemnity claims emergence. PCC had anticipated favorable indemnity claims emergence based upon prior claims development experience indicating that injured workers would be returning to work, thereby curtailing lost wage costs. PCC determined that the weak California employment environment had, however, hindered the ability of injured workers to return to work and indirectly influenced indemnity claims. The remaining $14.5 million of the $28.7 million reserve increase related primarily to an increase in LAE reserves arising in part from an increased use of outside counsel to assist in the settlement process, as well as a decrease in ceded loss and LAE reserves based on a review of reinsurance coverage estimates. The review of reinsurance coverage estimates also resulted in a $1.1 million decrease in ceded premiums earned, which increased net premiums earned.
The $13.4 million reserve increase in loss and LAE for 2010 relates primarily to a decrease in ceded loss and LAE reserves based on a fourth quarter 2010 review of reinsurance coverage estimates, which also resulted in a $5.0 million decrease in ceded premiums earned, thereby increasing net premiums earned in 2010, and, to a lesser extent, an increase in unallocated LAE reserves.
In 2012, we made a $15.0 million capital contribution to PCC.
Net Investment Income. The increase in net investment income for the reinsurance and insurance segments in 2012 from 2011 is due principally to the impact of including TransRe’s results commencing on the Acquisition Date, partially offset by a decrease in interest income in the insurance segment due to lower prevailing market yields.
Net Realized Capital Gains. Net realized capital gains in 2012, 2011 and 2010 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.
OTTI losses for 2010 reflect $12.3 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $12.3 million, $11.1 million related to equity security holdings, 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 severity and duration 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, 2012 were deemed to be temporary, based on, among other things: (i) the duration of time and the relative magnitude to which fair values of these securities have been below cost were not indicative of an OTTI loss (for example, no equity security was in a continuous unrealized loss position for twelve months or more as of December 31, 2012); (ii) the absence of compelling evidence that would cause us to call into question the financial condition or near-term prospects of the issuers of the securities; and (iii) our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery.
See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on gross unrealized investment losses for debt and equity securities as of December 31, 2012.
Earnings before income taxes in 2012 compared with the loss before income taxes in 2011 primarily reflects the gain on bargain purchase from the merger, partially offset by higher corporate administration expense and higher interest expense. The higher corporate administration expense in 2012 is due primarily to $33.8 million of
The lower interest, dividends and other - net in 2012 compared with 2011 primarily reflects significantly lower dividends, partially offset by higher interest income. Lower dividends are due primarily to the sale in January 2012 of shares of Exxon Mobil common stock held at the corporate-level. Higher interest income reflects the investment of proceeds arising from the issuance of Alleghany Senior Notes (as defined on page 82 of this Form 10-K) on June 26, 2012.
Our reinsurance and insurance operating units 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
(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 illnesses and environmental impairment liability; and credit.
Gross and Net Reserves. The significant increase in gross and net 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 Sandy.
As of December 31, 2012, we had total reinsurance recoverables of $1,348.6 million, consisting of $1,305.9 million of ceded outstanding loss and LAE and $42.7 million of recoverables on paid losses. The reinsurance purchased by our reinsurance and insurance operating units does not relieve them from their obligations to their policyholders and cedants, and therefore, the financial strength of their reinsurers is important.
Information regarding concentration of our reinsurance recoverables and the ratings profile of our reinsurers as of December 31, 2012 is as follows (in millions, except percentages):
(3) Approximately 92.5 percent of our reinsurance recoverables balance as of December 31, 2012 was due from reinsurers having an A.M. Best financial strength rating of “A” (Excellent) or higher.
We had no allowance for uncollectible reinsurance as of December 31, 2012.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that directly affect our reported financial condition and operating performance. More specifically, 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. We rely on historical experience and on various other assumptions that we believe 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 reported results to the extent that estimates and assumptions prove to be inaccurate.
Each of our reinsurance and insurance operating units 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 incurred but not reported, or “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.
Our insurance operating units provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and
as a result, these claims can have a very long claim tail, occasionally extending for decades. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long-tail casualty lines of business, 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 units will generally use actuarial projections in setting reserves for all casualty lines of business.
For RSUI, loss and LAE for 2012 and 2011 also include a $17.0 million increase and a $3.3 million net release of prior accident year loss reserves, respectively, primarily related to a re-estimation of case and IBNR reserves in the property line of business. For 2012, the $17.0 million reserve increase includes a $9.7 million loss recorded in the second quarter of 2012 related to Hurricane Ike in 2008. For 2011, the $3.3 million net reserve release primarily reflects significant reserve releases in non-catastrophe property reserves and unallocated LAE, partially offset by reserve increases related to prior year catastrophes.
Asbestos and Environmental Impairment Reserves. Loss and LAE include amounts for risks relating to asbestos-related illnesses 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 illnesses 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 illnesses and environmental impairment reserves are adequate as of December 31, 2012. See Note 12(d) to Notes to Consolidated Financial Statements set forth in Part II, Item 8 and pages 29 and 30 of this Form 10-K for additional information on loss and LAE for risks relating to asbestos-related illnesses and environmental impairment.
Reinsurance. Our reinsurance and insurance operating units 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 for other business without requiring additional capital. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance operating units would remain liable for such amounts not paid by their reinsurers. Recoverables recorded with respect to claims ceded to reinsurers under reinsurance contracts are predicated in large part on the estimates for unpaid losses and, therefore, are also subject to a significant degree of uncertainty. In addition to the factors cited above, reinsurance recoverables may prove uncollectible if a reinsurer is unable or unwilling to perform under a contract. Reinsurance purchased by our reinsurance and insurance operating units does not relieve them of their obligations to their own policyholders or cedants. Additional information regarding the use of, and risks related to, the use of reinsurance by our reinsurance and insurance operating units can be found on pages 31 and 32 and pages 41 and 42 of this Form 10-K. Also see Note 1(f) and Note 5 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our reinsurance recoverables.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing, able and knowledgeable market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, 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. Observable inputs are market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs are the reporting entity’s own assumptions about market participant assumptions based on the best information available under the circumstances. In assessing the appropriateness of using observable inputs in making fair value determinations, we consider whether the market for a particular security is “active” or not based on all the relevant facts and circumstances. A market may be considered to be inactive if there are relatively few recent transactions or if there is a significant decrease in market volume. Furthermore, we consider whether observable transactions are “orderly” or not. We do not consider a transaction to be orderly if there is evidence of a forced liquidation or other distressed condition, and as such, little or no weight is given to that transaction as an indicator of fair value.
The determination that an investment has incurred an OTTI loss in value requires the judgment of management and consideration of the fundamental condition of the issuer, its near-term prospects and all the relevant facts and circumstances.
If we intend to sell or it is more likely than not that we 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 the preceding, we will consider a debt security to be impaired when we believe it to be probable that we will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, we develop a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate we will not recover the full amount of its amortized cost basis in the security, we record an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the security. If applicable, the difference between the total unrealized loss position on the security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.
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 our 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 a 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.
See Note 1(b) and Note 4(e) to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our investments and investment impairments.
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 intangible assets that have an indefinite useful life are not subject to amortization.
In addition to the policies described above which contain critical accounting estimates, our other accounting policies are described in Note 1 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K. The accounting policies described in Note 1 require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities that do not meet the level of materiality required for a determination that the accounting policy includes critical accounting estimates. On an ongoing basis, we evaluate our estimates, including those related to the value of deferred acquisition costs, incentive compensation, income taxes, pension benefits and contingencies and
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, 2012, we held total marketable securities and cash of $731.7 million, compared with $1,234.9 million as of December 31, 2011. The decrease during 2012 primarily reflects the payment of the $816.0 million cash portion of our purchase price for TransRe, partially offset by $396.0 million of proceeds from the issuance of the Alleghany Senior Notes (discussed below). The $731.7 million is comprised of $463.5 million at the parent company, $90.0 million at AIHL and $178.2 million at the TransRe holding company level. 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, 2012.
Stockholders’ equity was approximately $6.4 billion as of December 31, 2012, compared with approximately $2.9 billion as of December 31, 2011. The increase in stockholders’ equity primarily reflects $2.7 billion from 8,360,959 shares issued pursuant to the merger and 2012 net earnings, including the gain on bargain purchase. As of December 31, 2012, we had 16,890,623 shares of our common stock outstanding, compared with 8,551,646 shares of our common stock outstanding as of December 31, 2011.
Credit Agreement. On September 9, 2010, we entered into a three-year credit agreement, or the “Credit Agreement,” with a bank syndicate, providing commitments, the “Commitments,” for a two tranche revolving credit facility in an aggregate principal amount of up to $100.0 million, consisting of (i) a secured credit facility, or “Tranche A,” subject to a borrowing base as set forth in the Credit Agreement, in an aggregate principal amount of up to $50.0 million, and (ii) an unsecured credit facility, or “Tranche B,” in an aggregate principal amount of up to $50.0 million. The Commitments under the Credit Agreement are scheduled to terminate on September 9, 2013, or the “Maturity Date,” unless terminated earlier. Borrowings under the Credit Agreement are available for working capital and general corporate purposes.
The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement requires us to, among other things, (i) maintain a consolidated net worth of not less than the sum of (x) approximately $2.0 billion plus (y) 50 percent of Alleghany’s accumulated, consolidated net earnings earned in each fiscal quarter (if positive) commencing September 30, 2010 and (ii) maintain a ratio of total indebtedness to total capital as of the end of each fiscal quarter of not greater than 0.25 to 1.0. Additionally, the Credit Agreement contains various negative covenants with which we must comply, including, but not limited to, limitations respecting the creation of liens on any property or asset; the incurrence of indebtedness; mergers, consolidations, liquidations and dissolutions; change of business; sales of assets; transactions with affiliates; and other provisions customary in similar types of agreements. In addition, at any time when a default has occurred and is continuing or would result therefrom, the Credit Agreement proscribes our ability to declare or pay, or permit certain of our subsidiaries to declare or pay, any dividend on, or make any payment on account of, or set apart assets for a sinking or other analogous fund for, the purchase, redemption, defeasance, retirement or acquisition of, any of our stock or any such subsidiaries.
Dividends from Subsidiaries. As of December 31, 2012, approximately $610.4 million of the equity of all of our subsidiaries was available for dividends or advances to us at the parent level. At that date, approximately $5.9 billion of our total equity of $6.4 billion was unavailable for dividends or advances to us from our subsidiaries.
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. From the Acquisition Date through December 31, 2012, TRC paid dividends of $100.0 million to TransRe.
Common Stock Repurchases. In July 2010, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management may determine advisable, up to an aggregate of $300.0 million. Such share repurchase program was terminated upon the entry in November 2011 into the Merger Agreement with Old TransRe. In October 2012, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.
In December 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. During 2010, we repurchased an aggregate of 285,056 shares of our common stock in the open market for $83.1 million, at an average price per share of $291.64. All of the foregoing per share and average price data has not been adjusted for subsequent Alleghany common stock dividends.
Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2012, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows (in millions):
the “2039 Notes;” and (ii) the “Alleghany Senior Notes,” which consist of the 2020 Senior Notes and the 2022 Senior Notes. See Note 8 to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for further details on the Senior Notes.
Our reinsurance and insurance operating units have obligations to make certain payments for loss and LAE pursuant to insurance policies and reinsurance contracts they issue. These future payments are reflected as reserves on our consolidated financial statements. With respect to loss and LAE, there is typically no minimum contractual commitment associated with insurance policies and reinsurance contracts, and the timing and ultimate amount of actual claims related to these reserves is uncertain.
Investments in Variable Interest Entities. In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited, or “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, or 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, utilizing the extensive reinsurance and capital market experience of the principals of Pillar Holdings. We have concluded that both Pillar Holdings and the Funds represent variable interest entities and that we are not the primary beneficiary, as we do not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, Pillar Holdings and the Funds are not consolidated, and are accounted for under the equity method of accounting. Alleghany’s potential maximum loss is limited to its aggregate investment of $200.0 million. As of December 31, 2012, our carrying value in Pillar Holdings and the Funds, as determined under the equity method of accounting, was $200.0 million, which is reported in other invested assets on our consolidated balance sheets.
insurance companies, the impact of such insurance was not significant to the debt securities credit quality rating as of December 31, 2012. As of December 31, 2012, the ratings of our debt securities portfolio was as follows (in millions, except percentages):
Effective duration measures a portfolio’s sensitivity to change in interest rates. In this regard, as of December 31, 2012, our debt securities portfolio had an effective duration of approximately 3.7 years compared with 4.0 years as of December 31, 2011. As of December 31, 2012, approximately $5.6 billion, or 35.0 percent, of our debt securities portfolio represented securities with maturities of five years or less. See Note 4 to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on the contractual maturities of our consolidated debt securities portfolio. We may modestly increase the proportion of our debt securities portfolio held in securities with maturities of more than five years should the yields of these securities provide, in our judgment, sufficient compensation for their increased risk. We do not believe that this strategy would reduce our ability to meet ongoing claim payments or to respond to significant catastrophe losses.
We may, from time to time, make significant investments in the common stock of a public company, subject to limitations imposed by applicable regulations.
Fair Value. The carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2012 and 2011 were as follows (in millions):
Valuation service providers typically obtain data about market transactions and other key valuation model inputs from multiple sources and, through the use of widely accepted internal valuation models, provide a single fair value measurement for individual securities for which a fair value has been requested under the terms of service agreements. The inputs used by the valuation service providers include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, currency rates, and other market observable information, as applicable. The valuation models take into account, among other things, market observable information as of the measurement date as well as the specific attributes of the security being valued including its term, interest rate, credit rating, industry sector, and
when applicable, collateral quality and other issue or issuer specific information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.
“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. Our Level 2 liabilities consist of the Senior Notes.
European securities. The following table provides a breakdown of the fair value, net unrealized gains (losses) and the average rating of our debt securities from governments and companies in Europe as of December 31, 2012 (in millions):
Projections of potential catastrophe losses are typically expressed in terms of the probable maximum loss, or “PML.” We define PML as our anticipated maximum loss (taking into account contract limits) caused by a single catastrophic event at a specified estimated return period affecting a broad contiguous area. These modeled losses are estimated based upon contracts in force at January 1, 2013 for TransRe and July 1, 2012 for RSUI.
interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We adopted this guidance in the first quarter of 2012, and the implementation did not have an impact on our results of operations and financial condition.
In June 2011, the FASB issued guidance on the presentation of comprehensive income. This guidance, as amended in December 2011, increases the prominence of other comprehensive income in the financial statements and eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. This guidance does not change the items that must be reported within other comprehensive income. This guidance is generally effective for interim and annual periods beginning after December 15, 2011. We adopted this guidance in the first quarter of 2012, and the implementation did not have an impact on our results of operations and financial condition.
In May 2011, the FASB issued guidance that addresses requirements for measuring fair value. Among other things, the guidance clarifies that the “highest and best use” valuation premise applies only to non-financial assets, and that premiums or discounts should be applied to valuations of an individual asset or liability only when market participants would do so. The guidance also permits measurement of fair value of financial instruments (that are carried at fair value) based on an entity’s net exposure to a particular market or credit risk on a net basis if there is evidence that the entity manages its financial instruments in this way. The guidance provides for additional financial statement disclosure regarding fair value measurements, including disclosure involving transfers between categories within the fair value hierarchy, and quantitative and qualitative information about fair value measurements that involve a significant degree of judgment. This guidance is effective for interim and annual periods ending after December 15, 2011. We adopted this guidance in the first quarter of 2012, and the implementation did not have a material impact on our results of operations and financial condition.
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. We will adopt this guidance in the first quarter of 2013, and we currently do not believe that the implementation will have a material impact on our results of operations and financial condition.
We have audited the accompanying consolidated balance sheet of Alleghany Corporation and subsidiaries (the “Company”) as of December 31, 2012, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
Alleghany’s equity investments, including those held by TransRe’s and AIHL’s operating units, are managed primarily by Alleghany Capital Partners LLC, an indirect, wholly-owned subsidiary of Alleghany. Alleghany also owns and manages properties in the Sacramento, California region through its subsidiary Alleghany Properties Holdings LLC (“Alleghany Properties”). On April 26, 2012, Alleghany’s majority-owned subsidiary BKH Holdings, Inc. acquired Bourn & Koch, Inc. (“BKI”), a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois.
In addition, Alleghany owns approximately 33 percent of the outstanding shares of common stock of Homesite Group Incorporated (“Homesite”), a national, full-service, mono-line provider of homeowners insurance, and approximately 38 percent of ORX Exploration, Inc. (“ORX”), a regional oil and gas exploration and production company. These investments are reflected in Alleghany’s financial statements in other invested assets. Alleghany also makes strategic investments in operating companies and conducts other activities at the parent level.
The accompanying consolidated financial statements include the results of Alleghany and its wholly-owned and majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company balances and transactions have been eliminated in consolidation. The results of TransRe are included from the Acquisition Date to December 31, 2012 and not in any prior periods, except with respect to “Supplemental Pro Forma Information” included in Note 2(e), and the results of BKI are included from April 26, 2012 to December 31, 2012 and not in any prior periods.
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.
Other invested assets include invested assets not identified above, primarily related to: (i) equity investments in operating companies where Alleghany has significant influence; (ii) partnership investments (including hedge funds and private equity funds); and (iii) loans receivable. Equity investments in operating companies where Alleghany has significant influence (an aggregate common stock position held at or above 20 percent is presumed to convey significant influence) are accounted for using the equity method. Partnership investments are accounted for as either AFS, or using the equity method where Alleghany has significant influence. Loans receivable are carried at unpaid principal balance.
Although Alleghany is responsible for the determination of the 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.
The three-tiered hierarchy used in management’s determination of fair value is broken down into three levels based on the reliability of inputs as follows:
“Level 1”-Valuations are based on unadjusted quoted prices in active markets that Alleghany has the ability to access for identical, unrestricted assets, and do not involve any meaningful degree of judgment. An active market is defined as a market where transactions for the financial instrument occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Alleghany’s Level 1 assets include publicly traded common stocks and mutual funds (which are included on the balance sheet in equity securities) where Alleghany’s valuations are based on quoted market prices.
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.
Premium balances receivable are reported net of an allowance for estimated uncollectible premium amounts. Such allowance is based upon an ongoing review of amounts outstanding, length of collection periods, the creditworthiness of the insured, and other relevant factors. Amounts deemed to be uncollectible are written off against the allowance.
Property and equipment is carried at cost, net of accumulated depreciation and amortization. Depreciation of buildings and equipment is principally calculated using the straight-line method over the estimated useful life of the respective assets. Estimated useful lives for such assets range from 3 to 20 years. Amortization of leasehold improvements is principally calculated using the straight-line method over the estimated useful life of the leasehold improvement or the life of the lease, whichever is less. Rental expense on operating leases is recorded on a straight-line basis over the term of the lease, regardless of the timing of actual lease payments.
Goodwill and other intangible assets deemed to have an indefinite useful life are tested annually in the fourth quarter of every year for impairment. Goodwill and other intangible assets are also tested whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. A significant amount of judgment is required in performing goodwill and other intangible asset impairment tests. These tests may include estimating the fair value of Alleghany’s operating units and other intangible assets. If it is determined that an asset has been impaired, the asset is written down by the amount of the impairment, with a corresponding charge to net earnings. Subsequent reversal of any impairment charge is not permitted.
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 unit may be less than its respective carrying amount, a second step is taken, involving a comparison between the estimated fair values of the operating units with their respective carrying amounts including goodwill. Under GAAP, fair value refers to the amount for which the entire operating unit may be bought or sold. The methods for estimating operating unit values include asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. All of these methods involve significant estimates and assumptions. 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 units 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.
A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. This determination is based upon a review of all available evidence, both positive and negative, including Alleghany’s earnings history, the timing, character and amount of future earnings potential, the reversal of taxable temporary differences and the tax planning strategies available.
The reserves for loss and LAE represent management’s best estimate of the ultimate cost of all reported and unreported losses incurred through the balance sheet date.
The cost resulting from all stock-based compensation transactions is recognized in the financial statements, with fair value as the measurement objective in accounting for stock-based compensation arrangements. The fair value-based measurement method applies in accounting for stock-based compensation transactions with employees. Non-employee directors are treated as employees for accounting purposes.
In July 2012, the Financial Accounting Standards Board (the “FASB”) issued revised guidance on the testing of certain intangible assets for impairment. This guidance simplifies how an entity tests for impairment of intangible assets other than goodwill, such as licenses and trade names, that are determined to have an indefinite life. The revised guidance allows an entity to first make a qualitative assessment to determine whether it is necessary to perform quantitative testing. Based on the results of such assessment, an entity will only be required to perform quantitative testing if it is more likely than not that the asset is impaired. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. Alleghany adopted this guidance in the fourth quarter of 2012, and the implementation did not have a material impact on its results of operations and financial condition.
In September 2011, the FASB issued revised guidance on the testing of goodwill for impairment. This guidance simplifies how an entity tests goodwill for impairment by allowing an entity to first make a qualitative assessment to determine whether it is necessary to perform quantitative testing. Based on the results of such assessment, an entity will no longer be required to perform quantitative testing if it is more likely than not that the fair value of a reporting unit is greater than its carrying value. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. Alleghany adopted this guidance in the first quarter of 2012, and the implementation did not have an impact on its results of operations and financial condition.
In May 2011, the FASB issued guidance that addresses requirements for measuring fair value. Among other things, the guidance clarifies that the “highest and best use” valuation premise applies only to non-financial assets, and that premiums or discounts should be applied to valuations of an individual asset or liability only when market participants would do so. The guidance also permits measurement of fair value of financial instruments (that are carried at fair value) based on an entity’s net exposure to a particular market or credit risk on a net basis if there is evidence that the entity manages its financial instruments in this way. The guidance provides for additional financial statement disclosure regarding fair value measurements, including disclosure involving transfers between categories within the fair value hierarchy, and quantitative and qualitative information about fair value measurements that involve a significant degree of judgment. This guidance is effective for interim and annual periods ending after December 15, 2011. Alleghany adopted this guidance in the first quarter of 2012, and the implementation did not have a material impact on its results of operations and financial condition.
Pursuant to the terms of the Merger Agreement, on the 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 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 is generally expected to be tax free to Old TransRe stockholders.
The excess of the fair value of the net assets acquired over the purchase price was recorded as a gain on bargain purchase of $494.9 million and is shown as a separate component of revenues in the statement of earnings for 2012. The gain on bargain purchase determination is consistent with the fact that prior to the merger, Old TransRe’s shares of common stock, similar to shares of certain other reinsurance and insurance companies, traded at a discount to book value per common share.
Alleghany’s total purchase price for Old TransRe as of the Acquisition Date is calculated in accordance with GAAP as follows (in millions, except per share amounts):
(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 Acquisition Date.
(2) The $816.0 million cash consideration was fixed as of the date of the Merger Agreement, predicated on the 57.4 million shares of common stock of Old TransRe outstanding at that date multiplied by $14.22 per share. Therefore, the additional 0.2 million of Old TransRe shares outstanding as of the Acquisition Date do not cause the cash consideration to increase and are adjusted for in this presentation.
Intangible assets - Establish fair value of intangible assets related to TransRe (see below for additional detail).
The net intangible assets (liabilities) included in “intangible assets” in the table above, and as of December 31, 2012, consist of the following (in millions):
Value of business in-force - Intangible asset resulting from the adjustment of unearned premiums to the estimated fair value of profit within TransRe’s unearned premiums as of the Acquisition Date, adjusted for a risk factor. This will be amortized as the contracts for business in-force as of the Acquisition Date expire.
State and foreign insurance licenses - Addition of the estimated fair value of identifiable intangible assets resulting from the merger arising from the ability to write reinsurance in all 50 U.S. states and the District of Columbia and various foreign jurisdictions.
Renewal rights - Addition of the estimated fair value of identifiable intangible assets resulting from the merger arising from renewal rights. This will be amortized over the net earnings pattern of renewed reinsurance contracts, estimated as of the Acquisition Date.
Gain contingency on dispute previously in arbitration - Estimated minimum recovery, net of estimated legal costs, from a dispute between TransRe and American International Group, Inc. (“AIG”) previously in arbitration, which was subsequently settled in the third quarter of 2012. See Note 12(a) for further discussion of the dispute previously in arbitration.
The following information summarizes the results of TransRe since the Acquisition Date that have been included within Alleghany’s Consolidated Statements of Earnings and Comprehensive Income (in millions):
(2) Among other adjustments, reflects adjustments to amortization expense on the TransRe Senior Notes resulting from the adjustment to their fair value as of the Pro Forma Acquisition Dates. Such adjustment reduced the interest expense of TransRe. See Note 8(b) for additional information on the TransRe Senior Notes. Also reflects adjustments to amortization expense associated with intangible assets arising from the merger.
(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.
(1) This table includes AFS investments (debt and equity securities as well as partnership investments carried at fair value that are included in other invested assets). This table excludes investments accounted for using the equity method and certain loans receivable that are carried at cost, all of which are included in other invested assets. The fair value of short-term investments approximates amortized cost. The fair value of all other categories of investments is discussed below.
Alleghany’s financial instruments measured at fair value and the level of the fair value hierarchy of inputs used as of December 31, 2012 and 2011 were as follows (in millions):
(2) There were no OTTI losses recorded in net earnings related to level 3 instruments still held as of December 31, 2012.
(4) Principally due to a decrease in observable inputs related to the valuation of such securities.
Net unrealized losses related to Level 3 investments as of December 31, 2012 and 2011 were not material.
* Of the $1,424.0 million and $871.0 million of fair value as of December 31, 2012 and 2011, respectively, $542.2 million and $573.3 million, respectively, related to certain energy sector businesses.
The amortized cost and estimated fair value of debt securities as of December 31, 2012 by contractual maturity are shown below (in millions). 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.
* Mortgage and asset-backed securities by their nature do not generally have single maturity dates.
As of December 31, 2012, non-income producing invested assets were insignificant.
Management’s assessment of equity securities initially involves an evaluation of all securities that are in an unrealized loss position, regardless of the duration or severity of the loss, as of the applicable balance sheet date. Such initial review consists primarily of assessing whether: (i) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; and (ii) Alleghany has the ability and intent to hold an equity security for a period of time sufficient to allow for an anticipated recovery (generally considered to be less than one year from the balance sheet date).
To the extent that an equity security in an unrealized loss position is not impaired based on the initial review described above, Alleghany then further evaluates such equity security and deems it to be other-than-temporarily impaired if it has been in an unrealized loss position for twelve months or more or if its unrealized loss position is greater than 50 percent of its cost, absent compelling evidence to the contrary.
Alleghany then evaluates those equity securities where the unrealized loss is 20 percent or more of cost as of the balance sheet date or which have been in an unrealized loss position continuously for six months or more preceding the balance sheet date. This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other-than-temporarily impaired including: (i) market valuation metrics associated with the equity security (e.g., dividend yield and price-to-earnings ratio); (ii) current views on the equity security, as expressed by either Alleghany’s internal stock analysts and/or by third party stock analysts or rating agencies; and (iii) discrete credit or news events associated with a specific company, such as negative news releases and rating agency downgrades with respect to the issuer of the investment.
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 the preceding, Alleghany will consider a debt security to be impaired when it believes it to be probable that Alleghany will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, Alleghany develops a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate Alleghany will not recover the full amount of its amortized cost basis in the security, Alleghany records an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the security. If applicable, the difference between the total unrealized loss position on the security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.
In developing the cash flow analyses for debt securities, Alleghany considers various factors for the different categories of debt securities. For municipal bonds, Alleghany takes 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, Alleghany discounts its 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. Alleghany’s 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, Alleghany reviews business prospects, credit ratings and available information from asset managers and rating agencies for individual securities.
OTTI losses for 2010 reflect $12.3 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $12.3 million, $11.1 million related to equity security holdings (primarily in the energy sector) and $1.2 million related to debt security holdings. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity and duration of the declines in fair value of such securities relative to their cost as of the balance sheet date.
As of December 31, 2012 and 2011, gross unrealized investment losses and related fair values for debt securities and equity securities, grouped by length of time in a continuous unrealized loss position, were as follows (in millions):
Alleghany reinsures portions of the risks it underwrites 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 Alleghany to increase gross premium writings and risk capacity without requiring additional capital. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, Alleghany’s reinsurance and insurance operating units would remain liable for such reinsurance portion not paid by their reinsurers.
Information regarding concentration of Alleghany’s reinsurance recoverables and the ratings profile of its reinsurers as of December 31, 2012 is as follows (in millions, except percentages):
(2) Represents the A.M. Best Company financial strength rating for the applicable reinsurance subsidiary or subsidiaries from which the reinsurance recoverable is due.
(3) Approximately 92.5 percent of Alleghany’s reinsurance recoverables balance as of December 31, 2012 was due from reinsurers having an A.M. Best Company financial strength rating of “A” (Excellent) or higher.
Alleghany’s reinsurance and insurance operating units reinsure portions of the risks they underwrite or assume with multiple reinsurance programs. A discussion of the more significant programs follows.
(1) Reinsurance recoverables in this table include only ceded loss reserves.
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, which caused widespread property damage and flooding to large areas of the East Coast and northeastern United States in October 2012.
Gross loss and LAE reserves as of December 31, 2011 decreased slightly from December 31, 2010, primarily reflecting reserve decreases in the casualty and workers’ compensation lines of business, largely offset by increases in the property lines of business. The decrease in the casualty gross loss and LAE reserves was $39.6 million, and primarily reflects the impact of releases in gross loss and LAE reserves by RSUI during 2011 related to prior accident years, partially offset by the impact of increases in gross loss and LAE reserves by CATA during 2011 related to prior accident years. The decrease in workers’ compensation gross loss and LAE reserves was $19.2 million, and primarily reflects the impact of PCC ceasing to solicit new or renewal business on a direct basis commencing August 1, 2009, partially offset by an increase in gross loss and LAE reserves by PCC related to prior accident years. The increase in property gross loss and LAE reserves was $42.3 million, and is due to increases in case reserves related primarily to significant catastrophe and other large losses incurred in 2011, partially offset by claim payments made by RSUI in 2011 related to catastrophe losses in prior years. Such claim payments caused RSUI to reduce its case reserves from prior accident years, primarily related to 2008 third quarter hurricane losses.
The above reserve changes included (decreases) increases in prior year net reserves, which are summarized for 2012 and 2011 as follows (in millions):
For CATA, loss and LAE for 2012 reflect a $13.2 million net increase of prior accident year loss reserves during the period, compared with a $5.0 million net increase of prior accident year loss reserves during 2011. Of the $13.2 million net increase in 2012, $22.2 million relates to certain specialty property and casualty classes of business written through a program administrator in connection with a program (the “Terminated Program Business”) in the 2010 and 2009 accident years, partially offset by a net decrease in prior year reserves in certain of CATA’s casualty and surety lines of business. The $13.2 million net reserve increase reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business. The $13.2 million net increase of prior accident year loss reserves did not impact the assumptions used in estimating CATA’s loss and LAE liabilities for business earned in 2012.
The $5.0 million net reserve increase in 2011 consists of a $14.6 million increase in reserves related to the Terminated Program Business, partially offset by a net reserve release in certain of CATA’s casualty lines of business. The reserve increase in the Terminated Program Business reflects unfavorable loss emergence, primarily in the 2009 and 2010 accident years, compared with claims development patterns assumed in earlier periods for such business.
For PCC, loss and LAE for 2012 reflect a $5.6 million increase of prior accident year workers’ compensation net loss and LAE reserves compared with a $28.7 million reserve increase of prior accident year workers’ compensation loss reserves during 2011. For 2012, the $5.6 million reserve increase primarily reflects unfavorable loss and LAE emergence compared with loss and LAE development patterns assumed in earlier periods.
The difference between the federal income tax rate and the effective income tax rate is as follows:
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
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 $15.3 million of deferred tax assets for certain state net operating and capital loss carryovers. A valuation allowance of $15.3 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.
The Internal Revenue Code provides for limits on the utilization of certain tax benefits following a corporate ownership change. Upon the closing of the merger, TransRe was subject to an annual limitation on its ability to use its foreign tax credit carryforwards and its minimum tax credit carryforwards. The total amount of foreign tax credit carryforwards and minimum tax credit carryforwards that were available prior to the merger are not diminished by this provision. The limitation provides for an annual limit on the amount of the carryforwards that can be used each year. The unused carryovers are available to be used in subsequent years, subject to the annual limitation. The annual limitation is estimated at approximately $42.7 million. The foreign tax credits expire between the tax years 2016 and 2022.
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 jurisdiction as of December 31, 2012:
In February 2008, Alleghany’s Board of Directors authorized the repurchase of shares of Common Stock, at such times and at prices as management determined advisable, up to an aggregate of $300.0 million. As of December 31, 2010, this program had been fully utilized. In July 2010, in anticipation of such full utilization, Alleghany’s board of directors authorized the repurchase of shares of Common Stock, at such times and at prices as management may determine advisable, up to an aggregate of $300.0 million. Such share repurchase program was terminated upon the entry in November 2011 into the Merger Agreement with Old TransRe. In October 2012, Alleghany’s Board of Directors authorized the repurchase of shares of Common Stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.
In December 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, Alleghany repurchased an aggregate of 399,568 shares of Common Stock in the open market for $120.3 million, at an average price per share of $301.14. During 2010, Alleghany repurchased an aggregate of 285,056 shares of Common Stock in the open market for $83.1 million, at an average price per share of $291.64. All of the foregoing per share and average price data has not been adjusted for subsequent Alleghany common stock dividends.
As of December 31, 2012, approximately $610.4 million of the equity of all of our subsidiaries was available for dividends or advances to Alleghany at the parent level. At that date, approximately $5.9 billion of Alleghany’s total equity of $6.4 billion was unavailable for dividends or advances to Alleghany from its subsidiaries.
TransRe’s operations are regulated in various jurisdictions with respect to currency, amount and type of security deposits, amount and type of reserves and amount and type of local investment. Regulations governing constitution of technical reserves and remittance balances in some countries may hinder remittance of profits and repatriation of assets. International operations and assets held abroad may be adversely affected by political and other developments in foreign countries, including possible tax changes, nationalization and changes in regulatory policy, as well as by consequences of hostilities and unrest. The risks of such occurrences and their overall effect upon TransRe vary from country to country and cannot easily be predicted.
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 units as of December 31, 2012 of $1.9 billion, a maximum of $127.4 million was available for dividends without prior approval of the applicable insurance regulatory authorities.
Statutory net income of Alleghany’s reinsurance and insurance operating units was $448.8 million and $147.4 million for the years ended December 31, 2012 and 2011, respectively. Combined statutory capital and surplus of Alleghany’s reinsurance and insurance operating units was $5.8 billion and $1.6 billion as of December 31, 2012 and 2011, respectively.
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 and $0.2 million as of December 31, 2012 and 2011, respectively. 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.
Alleghany leases certain facilities, furniture and equipment under long-term lease agreements. In addition, certain land, office space and equipment are leased under non-cancelable operating leases that expire at various dates through 2029. Rent expense was $21.2 million, $10.5 million and $10.5 million in 2012, 2011 and 2010, respectively. The aggregate minimum payments under operating leases with initial or remaining terms of more than one year as of December 31, 2012 were as follows (in millions):
As of December 31, 2012 and 2011, Alleghany had a concentration of market risk in its AFS equity securities portfolio with respect to certain energy sector businesses of $542.2 million and $573.3 million, respectively.
The insurance segment consists of property and casualty insurance operations conducted by AIHL through its insurance operating units RSUI, CATA and PCC. RSUI also writes a modest amount of business on an assumed basis, which is included in the insurance segment.
The primary components of “corporate activities” are Alleghany Properties, Alleghany’s investments in Homesite and ORX and strategic investments and other activities at the parent level. As of April 26, 2012, corporate activities also includes the operating results of BKI. Corporate activities also includes interest expense associated with the Alleghany Senior Notes, whereas interest expense associated with the TransRe Senior Notes is included in “Total Segments.”
Segment results for Alleghany’s two reportable segments and for corporate activities for 2012 (which include TransRe from the Acquisition Date through December 31, 2012), 2011 and 2010 are shown in the tables below:
(1) Casualty & other 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; and credit.
(3) Includes amortization associated with deferred acquisition costs of $578.1 million, $141.4 million and $143.8 million for the years ended December 31, 2012, 2011 and 2010, respectively.
From the Acquisition Date through December 31, 2012, three large international brokers accounted for approximately 26 percent, 21 percent and 12 percent of gross premiums written in the reinsurance segment.
As of December 31, 2012, 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 stock options and restricted stock, including restricted stock units.
Amounts recognized as compensation expense in the consolidated statements of earnings and comprehensive income with respect to long-term compensation awards under plans for parent-level employees and directors were $19.4 million, $2.8 million and $6.5 million in 2012, 2011 and 2010, respectively. The amount of related income tax benefit recognized as income in the consolidated statements of earnings and comprehensive income with respect to these plans was $6.8 million, $1.0 million and $2.3 million in 2012, 2011 and 2010, respectively. In 2012, 2011 and 2010, $4.9 million, $1.8 million and $2.1 million of Common Stock at fair market value, respectively, and $5.3 million, $5.8 million and $2.9 million of cash, respectively, was paid by Alleghany under plans for parent-level employees and directors. As noted above, as of December 31, 2012 and December 31, 2011, all outstanding awards were accounted for under the fair-value-based method of accounting.
In 2010, Alleghany established the 2010 Directors’ Stock Plan which provides for the automatic grant of nonqualified options to purchase 500 shares of Common Stock, as well as an automatic grant of 250 shares of restricted Common Stock or, under certain circumstances, restricted stock units, to each non-employee director on an annual basis. Awards granted to non-employee directors were not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2012.
Performance Share Awards - Participants are entitled, at the end of a four-year award period, to a maximum amount equal to the value of one and one-half shares of Common Stock for each performance share issued to them based on market value on the payment date. Payouts are made provided defined levels of performance are achieved. Expenses are recorded based on changes in the fair value of the awards. The fair value is calculated based primarily on: the value of Common Stock as of the balance sheet date; the degree to which performance targets specified in the 2007 LTIP and 2012 LTIP have been achieved; and the time elapsed with respect to each award period.
RSUI has a Restricted Stock Unit Plan (the “RSUI Plan”) for the purpose of providing equity-like incentives to key employees of RSUI. Under the RSUI Plan, restricted stock units (“units”) are issued. Additional units, defined as the “Deferred Equity Pool,” were issued in 2012, 2011 and 2010 and may be created in the future if certain financial performance measures are met. Units may only be settled in cash. The fair value of each unit is calculated as stockholder’s equity of RSUI, adjusted for certain capital transactions and accumulated compensation expense recognized under the RSUI Plan, divided by the sum of RSUI common stock outstanding and the original units available under the RSUI Plan. The units vest on the fourth anniversary of the date of grant and contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2012, 2011 and 2010, RSUI recorded $21.0 million, $26.2 million and $29.6 million, respectively, in compensation expense related to the RSUI Plan. During the same periods, a deferred tax benefit of $7.4 million, $9.2 million and $10.4 million, respectively, related to the compensation expense was recorded.
TransRe has a Book Value Unit Plan (the “TransRe Plan”) for the purpose of providing equity-like incentives to key employees of TransRe. Under the TransRe Plan, book value units (“BVUs”) are issued. BVUs may only be settled in cash. The fair value of each BVU is calculated as stockholders’ equity of TransRe, adjusted for certain capital transactions, divided by the adjusted number of BVUs outstanding. Pursuant to the terms of the Merger Agreement, certain Old TransRe restricted stock units held by current or former employees were converted into BVUs. BVUs have vesting dates of up to the fourth anniversary of the date of grant, with converted Old TransRe restricted stock units retaining their pre-conversion vesting dates. The BVUs contain certain restrictions, relating to, among other things, forfeiture in the event of termination of employment and transferability. In 2012, TransRe recorded $63.9 million in compensation expense and a deferred tax benefit of $22.4 million related to the TransRe Plan.
Alleghany has an unfunded, noncontributory defined benefit pension plan for parent-level executives and a funded, noncontributory defined benefit pension plan for parent-level employees. The executive plan currently provides for designated employees (including all of Alleghany’s current executive officers) retirement benefits in the form of an annuity for the joint lives of the participant and his or her spouse or, alternatively, actuarially equivalent forms of benefits, including a lump sum. With respect to the non-contributory defined benefit pension plan for employees, Alleghany’s policy is to contribute annually the amount necessary to satisfy the Internal Revenue Service’s funding requirements. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The projected benefit obligation as of December 31, 2012 and 2011 was $26.4 million and $21.6 million, respectively, and the related fair value of plan assets was $2.7 million and $2.7 million, respectively.
TransRe also has an unfunded, noncontributory defined benefit plan and a funded noncontributory defined benefit plan for some of its employees in the United States. Benefits under TransRe’s defined benefit plans are frozen as of December 31, 2009. As of December 31, 2012, the projected benefit obligation was $55.3 million and the related fair value of plan assets was $47.0 million.
Alleghany provides supplemental retirement benefits through deferred compensation programs and profit sharing plans for certain of its parent-level officers and employees. In addition, Alleghany’s subsidiaries sponsor both qualified, defined contribution retirement plans for substantially all employees, including executives, and non-qualified plans only for executives, some of which provide for voluntary salary reduction contributions by employees and matching contributions by each respective subsidiary, subject to specified limitations.
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
These other employee retirement plans are not material to Alleghany’s results of operations, financial condition or cash flows for the three years ended December 31, 2012.
Selected quarterly financial data for 2012 and 2011 are presented below (in millions, except per share amounts):
We have audited Alleghany Corporation and subsidiaries internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Alleghany Corporation and subsidiaries management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
In our opinion, Alleghany Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Allegheny Corporation and subsidiaries as of December 31, 2012, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for year then ended of Alleghany Corporation and subsidiaries and our report dated February 21, 2013 expressed an unqualified opinion thereon.