Consolidated gross realized gains were $7.3 million for the year ended December 31, 2004, as compared to $118.4 million and $38.9 million in 2003 and 2002, respectively. Included in consolidated gross realized gains for the year ended December 31, 2003 were gains of approximately $57.6 million from the disposition of four real estate holdings during the first quarter. Additionally, during the third quarter of 2003, the Company reallocated its investment portfolio, reducing its equity holdings by approximately $86.3 million, resulting in realized gains of approximately $48.8 million. Consolidated gross realized losses were $2.1 million, $4.8 million and $12.3 million for the years ended December 31, 2004, 2003 and 2002, respectively. Included in consolidated gross realized losses for the years ended December 31, 2004 and 2003 were write downs of approximately $0.1 million and $4.0 million, respectively, from the recognition of other than temporary impairments on certain investment securities.
Consolidated losses and loss adjustment expenses totaled $409.7 million for the year ended December 31, 2004, compared to $395.3 million in 2003 and $334.6 million in 2002. Improvement in the consolidated loss ratio in 2004 as compared to 2003 was primarily attributable to the risk management segment shifting to loss sensitive policies, which typically have a lower loss ratio than guaranteed cost policies. Partially offsetting this improvement was $17.7 million in losses and loss adjustment expenses related to the hurricane activity that impacted the southeastern United States during the third quarter. The improvement in the loss ratio in 2003 as compared to 2002 was primarily attributable to $59.8 million of reserve strengthening recorded in the run-off segment during 2002. Consolidated loss reserves were $1,607.5 million, $1,480.8 million and $1,281.6 million as of December 31, 2004, 2003 and 2002, respectively.
Consolidated underwriting, acquisition and insurance costs were $222.8 million, $191.0 million and $144.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in the expense ratio in 2004 as compared to 2003 was primarily attributable to the integration of the renewals rights agreements entered into within the specialty commercial and public entity segments during the fourth quarter of 2003. Improvement in the expense ratio during 2003 as compared to 2002 was primarily attributable to economies of scale realized from increased premium volumes.
Interest expense was $11.0 million, $8.4 million and $0 for the years ended December 31, 2004, 2003 and 2002, respectively. Interest expense resulting from the junior subordinated debentures was $3.6 million in 2004 compared to $0.6 million recorded in 2003. During 2004, the Company issued an additional $85.6 million in junior subordinated debentures. Interest expense for funds withheld under a retroactive reinsurance contract totaled approximately $6.9 million and $6.6 million for the years ended December 31, 2004 and 2003, respectively. Interest expense for various other funds withheld by the insurance subsidiaries totaled $0.5 million and $1.3 million for the years ended December 31, 2004 and 2003, respectively.
In evaluating the operating performance of its segments, the Company focuses on core underwriting and investing results before consideration of realized gains or losses from the sales of investments. Management excludes realized gains for the evaluation of segment results, as decisions regarding the sales of investments are made at the corporate level. Although this measure of profit (loss) does not replace net income (loss) computed in accordance with accounting principles generally accepted in the United States as a measure of profitability, management utilizes this measure of profit (loss) to focus its segments on generating operating income which excludes realized gains and losses on sales of investments.
On March 31, 2003, Colony entered into a quota share reinsurance agreement with HCC Insurance Holdings, Inc. (“HCC”). Under the terms of this agreement, the Company cedes 15% of the gross written premiums from the excess and surplus lines segment to HCC and HCC will, in turn, assume 15% of the losses. For the year ended December 31, 2004, the Company ceded $62.0 million of gross written premiums, $58.5 million of earned premiums and $35.7 million in losses and loss adjustment expense. For the year ended December 31, 2003, the Company ceded $41.3 million of gross written premiums, $17.1 million of earned premiums and $10.1 million in losses and loss adjustment expense. The Company receives a ceding commission to offset its acquisition costs related to these premiums. For the years ended December 31, 2004 and 2003, the Company earned a ceding commission of $11.6 million and $3.0 million, respectively.
The expense ratio for the year ended December 31, 2004 was 29.4%, which is consistent with the expense ratio of 29.2% for the same period ending 2003. The expense ratio was 31.3% for the year ended December 31, 2002 was impacted by expenses relating to a renewal rights acquisition entered into in May 2002.
Included in gross written premiums above are amounts derived from writing and servicing workers’ compensation policies for insurance programs marketed by certain state funds in jurisdictions where the state funds are not licensed. The Company receives a ceding commission and cedes 100% of the premiums and related losses to the respective state fund. Gross written premiums for the state fund business were $28.3 million in 2004 and $14.4 million in 2003.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share reinsurance program to assume directors and officers liability premiums and losses on policies underwritten by subsidiaries of HCC. Under the terms of the agreements, Argonaut Insurance Company assumed 3.33% of premiums and losses under HCC’s USA Directors and Officers Liability program and 5% of premiums and losses under HCC’s International Directors and Officers Liability program for 2003. The percentage assumed by the Company for both programs was reduced to 1.5% effective January 1, 2004, and was renewed in 2005. Gross written premiums assumed under these programs totaled $9.1 million and $12.6 million, respectively, for the years ended December 31, 2004 and 2003. The decrease in the gross written premiums in 2004 as compared to 2003 was the result of the reduction of the percentage of such business assumed.
Earned premiums decreased 5% to $116.0 million for the year ended December 31, 2004 from $122.4 million for the same period in 2003. This decrease was driven by a $31.7 million reduction in earned premiums for non-strategic products which the Company is exiting, primarily attributable to reductions in programs for small guaranteed cost accounts and wrap ups. Partially offsetting these decreases was $15.1 million in additional earned premiums for casualty risk management accounts. The $15.1 million is net of $16.6 million of return premium on retrospectively rated policies which was caused by favorable loss development, primarily on the 2001, 2002 and 2003 accident years. There was $10.7 million in additional premium earned in 2004 compared to 2003 under the above referenced HCC agreement.
Losses and loss adjustment expenses for the year ended 2003 included adverse development of approximately $5.0 million attributable to one multi-year construction account that was non-renewed in January 2004 and a $5.0 million charge related to an increase in the allowance for doubtful accounts for balances due from reinsurers. In the aggregate, the adverse development and increase to the allowance account resulted in an increase of approximately eight points in the 2003 calendar year loss ratio. Losses and loss adjustment expenses in 2002 include approximately $13.0 million (approximately 12 points of the stated loss ratio) related to the construction account noted above.
The expense ratio for the year ended 2004 was 44.9% versus 49.9% in 2003 and 47.7% in 2002. The increase in the expense ratio in 2003 versus 2002 was primarily attributable to $1.9 million of expense for the settlement of a lawsuit and restructuring charges of $1.3 million. With the elimination of non-strategic products, Argonaut Insurance Company reduced its workforce by 67 employees in the first quarter of 2003. The restructuring effort along with continued expense management initiatives have resulted in decreased levels of expenses for 2004 compared to prior years. Due to the loss sensitive nature of the business underwritten by risk management, the expense ratio is higher than if the business were written on a guaranteed cost basis. This is due to the insured receiving a premium credit for participating in the losses on the policy while the costs to underwrite the policy are similar to a guaranteed cost product.
Net investment income improved to $29.9 million for the year ended December 31, 2004 due primarily to higher yields resulting from the reallocation of the investment portfolio in the latter half of 2003. The Company reduced its investment in equity holdings and invested the proceeds in fixed maturity investments, which tend to have a higher yield. Net investment income declined to $27.3 million for the year ended December 31, 2003 as compared to $31.4 million in 2002 due to lower yields. Partially offsetting the decrease in 2003 as compared to 2002 were higher invested balances due primarily to capital contributions. Invested assets as of December 31, 2004 were $657.5 million compared to $709.0 million as of December 31, 2003 and $629.0 million as of December 31, 2002. The decline in invested assets in 2004 as compared to 2003 was primarily attributable to claim payments coupled with a capital allocation to the public entity segment.
The following table summarizes the results of operations for the specialty commercial segment:
The increase in gross written premiums for the year ended December 31, 2004 as compared to the same periods in 2003 and 2002 was primarily attributable to new business written as a result of the Grocers renewal rights agreement. Gross written premiums resulting from new business were $90.7 million for the year ended December 31, 2004, compared to $33.3 million and $31.1 million for the same periods ended in 2003 and 2002, respectively. The renewals rights agreement contributed $56.0 million in gross written premiums during 2004. Gross written premiums resulting from renewal business were $120.7 million, $110.6 million and $96.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in renewal business in the current year as compared to 2003 was due to rate increases and to a lesser extent increased exposure relative to payroll on workers’ compensation policies. The increases in renewal premiums in 2003 compared to 2002 were attributable to rate increases. The increase in earned premiums was primarily attributable to the increases in gross written premiums for all years presented.
Public Entity. Trident functions as a managing general underwriter, dedicated to servicing the insurance needs of preferred small to intermediate sized governmental entities throughout the United States. Trident offers a comprehensive insurance package, including property, inland marine, crime, general liability, public officials’ liability, law enforcement liability, automobile liability, automobile physical damage and excess liability coverages. Trident currently underwrites the majority of its products through Argonaut Great Central and Argonaut Insurance Company.
The increase in gross written premiums for the year ended December 31, 2004 was primarily attributable to an increase in renewal business written in 2004 as compared to 2003 and 2002, coupled with new business generated from a renewal rights acquisition in the fourth quarter of 2003. For the year ended December 31, 2004, the public entity segment wrote $53.7 million in renewal business as compared to $29.4 million and $11.9 million for the same periods in 2003 and 2002, respectively. New business written by this segment was $34.2 million for the year ended December 31, 2004, including $18.4 million in premium resulting from the 2003 renewal rights transaction. New business for the years ended December 31, 2003 and 2002 was $33.1 million and $21.9 million, respectively. The increases in earned premiums were primarily the result of increased gross written premiums for all years presented.
Losses and loss adjustment expenses for the year ended December 31, 2004 resulted in a loss ratio of 64.7% compared to 63.3% in 2003 and 70.4% for 2002. The increase in the loss ratio in 2004 is attributable to approximately $1.2 million of net catastrophe losses due to the hurricane activity in the southeastern United States during the third quarter of 2004. The decrease in the loss ratio in 2003 is attributable to the maturation of the book of business as well as a decrease in the percentage of business reinsured through quota share arrangements. Loss reserves for the public entity segment were $60.0 million, $28.8 million and $11.5 million as of December 31, 2004, 2003 and 2002, respectively.
Run-off Lines. The Company has discontinued active underwriting of certain lines of business; however, the Company is still obligated to pay losses incurred on these lines which include general liability and medical malpractice policies written in past years. The lines currently in run-off are typically characterized by long elapsed periods between the occurrence of a claim and ultimate resolution of the claim. The Company maintains a specialized staff dedicated solely to administering and settling these claims.
Argonaut Insurance Company is exposed to asbestos liability at the primary level through claims filed against its direct insureds, as well as through its position as a reinsurer of other primary carriers. Argonaut Insurance Company’s direct liability arises primarily from policies issued from the mid 1970s to early 1980s which pre-dated policy contract wording that excluded asbestos exposure. During 2004 the Company settled its largest direct exposure for $29.8 million (see discussion below). The majority of the policies were issued on behalf of small contractors or construction companies. The Company believes that the frequency and severity of asbestos claims for such insureds is typically less than that experienced for large, industrial manufacturing and distribution concerns.
Argonaut Insurance Company also assumed risk as a reinsurer for a limited period of time, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance Company also reinsured risks on policies written by domestic carriers. Such reinsurance typically provided coverage for limits attaching at a relatively high dollar amount which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance Company are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no current medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that claims generated out of this population of claimants may result in incurred losses generally lower than the asbestos claims filed over the past decade and could be below Argonaut Insurance Company’s attachment level.
The following table represents a reconciliation of total gross and net reserves for the run-off lines for each of the years in the three-year period ended December 31, 2004. Amounts in the net column are reduced by reinsurance recoverables.
In 2003, the Company completed its analysis of the recoverability of loss and loss adjustment expense reserves for its run-off lines which include asbestos and environmental claims for its run-off lines. This analysis resulted in a decrease to ceded loss and loss adjustment expense reserves, and a corresponding increase to net loss and loss adjustment expense reserves and a related expense of $10.2 million. The Company revised its analysis that projects anticipated future ceded reinsurance recoveries relative to existing claims and incurred but not reported claims. The analysis relied on identification of reinsurance contracts that the Company purchased at the time the policies were in force. These reinsurance contracts provide coverage for specific policy contracts for which the Company has claim exposure. Previously, the Company utilized historical relationships of ceded losses to gross losses to estimate expected future ceded losses. The current approach incorporates more of the specific characteristics of the existing and expected claims, or related policies and reinsurance contracts. Accordingly, management believes it provides a more refined estimate of expected future ceded loss recoveries.
Total reserves for run-off lines as of December 31, 2004 were $195.3 million, net of reinsurance but before effects of the adverse development cover, including reserves for asbestos and environmental claims of $162.0 million. (Additional information relating to the ADC is included under Item 1 “Business - Reinsurance” on pages 7 - 10). Management uses various actuarial methods to determine its best estimate of losses for the run-off lines in total, which resulted in a range of potential ultimate liability, net of reinsurance, of $130.3 million to $278.3 million. In determining its best estimate, management primarily relied on the report year method, with some weight given to other methods. The report year method relies most heavily on the Company’s historical claims and severity information, whereas other methods rely more heavily on industry information. This method produces an estimate of losses which have been incurred but not yet reported based on projections of numbers of future claims and the average severity for those future claims. The severities were calculated based on the Company’s specific data and in management’s opinion best reflect the Company’s liabilities based upon the insurance policies issued. As a result of this reserve analysis, the reserve for incurred but not reported asbestos and environmental claims (net of reinsurance) at December 31, 2004, was $89.4 million compared to $99.6 million and $102.1 million as of December 31, 2003 and 2002, respectively. The reserve for incurred but not reported claims for the remaining run-off lines (net of reinsurance) was $12.7 million as of December 31, 2004, compared to $11.8 million and $15.3 million as of December 31, 2003 and 2002, respectively.
New claims in the reinsurance assumed categories are primarily the result of the Company typically providing coverage for higher limits which are payable only after other layers of reinsurance are exhausted. Additionally, there tend to be long delays in the ceding companies reporting claims to the reinsurers.
Included in the gross payments on closed claims in 2004 is a settlement relating to the Western MacArthur litigation. The Company, through its subsidiary Argonaut Insurance Company, was named in various legal actions filed by Western MacArthur Company, Western Asbestos Company (the “MacArthur Companies”) and certain other individual claimants. Argonaut Insurance Company’s involvement in these actions arose from nine construction wrap-up policies with an occurrence limit of $200,000 per policy issued to Western MacArthur Company and Western Asbestos Company, respectively, for liability arising out of work performed on five construction sites in the 1960’s and 1970’s. On April 14, 2004, the Bankruptcy Court presiding over the Chapter 11 Bankruptcy of the MacArthur Companies entered orders giving final approval to settlements reached with all property and casualty insurers of the MacArthur Companies currently in litigation, including Argonaut Insurance Company. A bankruptcy reorganization plan filed by the MacArthur Companies will be implemented and all existing and future claims against the MacArthur Companies related to asbestos will be channeled solely to a trust. Argonaut Insurance Company contributed $29.8 million into the bankruptcy trust and received a release from the MacArthur Companies as to any and all existing or future asbestos-related claims, including any claims for extra-contractual relief, arising directly or indirectly out of any alleged coverage under the nine Argonaut Insurance Company polices at issue. In addition, claimants seeking funds from the trust will be required to execute release and indemnity agreements in favor of Argonaut Insurance Company as a condition to receiving payment. The Company ceded the majority of its $29.8 million contribution to its reinsurers.
Because of the types of coverages within Argonaut Insurance Company’s run-off lines of business, a significant amount of subjectivity and uncertainty exists in establishing the reserves for losses and loss adjustment expenses. Factors that increase these uncertainties are: (1) lack of historical data, (2) inapplicability of standard actuarial projection techniques, (3) uncertainties regarding ultimate claim costs, (4) coverage interpretations, and (5) the judicial, statutory and regulatory environments under which these claims may ultimately be resolved. Significant uncertainty remains as to the ultimate liability to the Company due to the potentially long waiting period between exposure and emergence of any bodily injury or property damage and the resulting potential for involvement of multiple policy periods for individual claims. Additionally, recent industry trends show an increasing number of claims being filed by individuals who claim asbestos exposure, but who have no symptoms of asbestos-related disease. Due to these uncertainties, the current trends may not be indicative of future results. Although management has determined and recorded its best estimate of the reserves for losses and loss adjustment expenses for run-off lines, current judicial and legislative decisions continue to broaden liability, expand policy scopes and increase the severity of claims payments. As a result of these and other recent developments, the uncertainties inherent in estimating ultimate loss reserves are heightened, further complicating the already complex process of determining loss reserves. The industry as a whole is involved in extensive litigation over these coverages and liability issues, and must contend with the continuing uncertainty in its effort to quantify these exposures.
earned thereon, and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of the Company’s loss and loss expenses are paid out over more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payrolls and general overhead expenses.
Net cash used by investing activities totaled $245.8 million, $336.1 million and $40.7 million for the years ended December 31, 2004, 2003 and 2002, respectively. Cash was primarily used to acquire fixed maturity investments, offset by cash received from sales, calls and maturities of fixed asset securities and sales of equity securities. As of December 31, 2004 and 2003, $112.4 million and $179.1 million of the investment portfolio were invested in short-term, liquid investments.
Net cash provided by financing activities totaled $83.8 million for the year ended December 31, 2004, and was primarily attributable to the Company’s issuance of junior subordinated debentures (see discussion below). Net cash provided by financing activities totaled $149.6 million for the year ended December 31, 2003, and was attributable to the issuance of preferred stock, common stock and junior subordinated debentures. Net cash used in financing activities totaled $12.7 million for the year ended December 31, 2002, and was primarily attributable to the payment of dividends to common shareholders.
During the first quarter of 2003, the Board of Directors suspended the payment of dividends to common shareholders to support the capital needs of the Company. Additionally, under the terms of the preferred stock offering, the Company agreed to suspend dividend payments to common shareholders until April 2005. For the year ended December 31, 2002, quarterly dividends to common shareholders were $0.15 per share, for a total of $0.60 per share. Cash dividends paid to preferred shareholders totaled $2.5 million and $1.2 million for the years ended December 31, 2004 and 2003, respectively.
During 2003, the Company, through a series of statutory trusts, sold $27.0 million of Floating Rate Capital securities (the “Capital Securities) (liquidation amount $1,000 per Capital Security) in a series of private sales. In conjunction with the sales of the Capital Securities, the trusts sold $0.8 million of Floating Rate Common Securities to the Company. The trusts used the proceeds from these sales to purchase $27.8 million of Floating Rate Junior Subordinated Debentures (the “Debentures”) from the Company. The interest rates on the Debentures and the Capital Securities are equal to the 3-Month LIBOR plus a margin of 4.10%, reset quarterly. The interest rates are not to exceed 12.5% prior to the coupon cap date, which is approximately 5 years after the issuance date. The Debentures are unsecured and are subordinate in right of payment to all of the Company’s future
On September 22, 2004, the Company entered into a $25 million Credit Facility (the “Revolver Facility”) with LaSalle Bank National Association as Administrative Agent and various other financial institutions as lenders. This Revolver Facility was arranged to meet working capital needs of the Company. The Revolver Facility provides for interest at a variable interest rate based on LIBOR plus a margin ranging from 200 to 250 basis points, as determined by the underlying leverage ratio (debt to total capitalization) of the Company. As of December 31, 2004, no borrowing capacity had been utilized under the Revolver Facility agreement. The Revolver Facility expires on September 22, 2006, and is thereafter renewable on an annual basis. The facility has four significant covenants, including (i) the ratio of total funded debt to total capitalization; (ii) the level of the Company’s consolidated net worth; (iii) interest coverage ratios; and (iv) RBC ratios of the key operating units. The Company is in compliance with all financial covenants of the Revolver Facility as of December 31, 2004.
As of December 31, 2004, the Company had repurchased and retired approximately 7.9 million shares of its common stock out of a total 10 million shares authorized for repurchase. No shares were repurchased and retired during 2004.
The Company invests excess cash in a variety of investment securities. As of December 31, 2004, the Company’s investment portfolio consisted of 82.4% fixed maturities, 10.2% equities, 1.1% other long-term investments and 6.3% short-term investments, compared to 76.7% fixed maturities, 11.0% equities, 0.8% other long-term investments and 11.5% short-term investments for the same period in 2003. The Company classifies its investment portfolio as available for sale; therefore all investments are reported at fair market value, with unrealized gains and losses being reported as a component of shareholders’ equity. During 2003, the Company re-allocated its investment portfolio, reducing its concentration in equity investments. Due to the reallocation of the portfolio, combined with temporary declines in the market value of its investments, shareholders’ equity was reduced by approximately $10.7 million, net of tax, due to the reduction of unrealized gains. As of December 31, 2004, the Company had no investment in any one security that exceeded 10% of shareholders’ equity.
The Company maintains a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard its financial position. The additional reinsurance costs of the Company’s program, to the extent not passed on to customers through increased rates may have a negative impact on liquidity.
The Company entered into a retroactive adverse loss development reinsurance agreement (“ADC”) on December 31, 2002 and initially ceded $125 million of carried reserves for the workers’ compensation, commercial multiple peril, general liability and asbestos, environmental and other latent losses lines of business. At December 31, 2004, $131.9 million has been recorded as reinsurance funds withheld related to the ADC. (Additional information relating to the ADC is included under Item 1 “Business - Reinsurance” on pages 7 - 10).
The insurance subsidiaries must maintain certain levels of policyholders’ surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners suggest that a property and casualty insurer’s ratio of annual statutory net premium written to policyholders’ surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the insurance subsidiaries to their combined policyholders’ surplus was 1.3-to-1 as of December 31, 2004. Current levels of policyholders’ surplus are adequate to support current premium writings, based on this standard. The Company monitors premium and statutory surplus levels of the insurance subsidiaries to ensure that the subsidiaries maintain adequate premiums to surplus ratios. Failure of any insurance subsidiary to maintain adequate levels of policyholders’ surplus could negatively impact the ability to write additional premiums.
In addition, regulators and rating agencies utilize a risk based capital (“RBC”) test designed to measure the acceptable amount of surplus an insurer should maintain, based on specific inherent risks of each insurer. Insurers failing to meet this benchmark level may be subject to scrutiny by the insurer’s domiciliary insurance department and potentially result in rehabilitation or liquidation. At December 31, 2004, the total adjusted capital of each of the Company’s insurance subsidiaries exceeded the minimum levels required under RBC. The Company continually monitors the RBC ratios and will implement strategies to maintain ratios above the regulatory minimums.
The Company is also exposed to credit risk on losses recoverable from reinsurers and premiums receivable from insureds. The Company mitigates this risk by limiting concentrations of exposure to any one company. However, downturns in one sector or market can adversely impact other sectors and may result in higher credit exposure. The Company does not utilize credit default swaps to mitigate its credit exposure from either investments or counterparties.
The determination of pension plan expense and the requirements for funding the Company’s pension plans are based on a number of actuarial assumptions. Management’s selection of plan assumptions, primarily the discount rate used to calculate the projected benefit obligation and the expected long-term rate of return on plan assets, can have a significant impact on the resulting estimated projected benefit obligation and pension cost, and thus on the consolidated results of operations. Such plan assumptions are determined annually, subject to revision if significant events occur during the year.
The pension plan measurement date for purposes of the consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which management believes the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2004, the Company used the following assumptions: a discount rate of 5.75% and an expected rate of return on plan assets of 5.75%.
David Hartoch Swett & Crawford, a member of the Aon family of companies, is the largest wholesale insurance broker in the country, placing nearly $3 billion in premium volume in their most recent fiscal year. David Hartoch, who is a member of the Company’s Board of Directors, was the Chairman and Chief Executive Officer of Swett & Crawford from 1997 to 2003 and is currently a consultant to them. During 2004, the Company, through its excess and surplus segment, placed insurance through Swett & Crawford totaling $13.2 million in gross written premiums. Swett & Crawford earned $2.2 million in commissions on this business.
Allan W. Fulkerson In August, 2002, the Company committed to a $5.0 investment, as a limited partner, in Century Capital Partners III, L.P. (“CCPIII”), an investment partnership which specializes in investing in the insurance industry. In April 2003, CCPIII purchased 500,000 shares of the Company’s Series A Mandatory Convertible Preferred Stock (see note 9 “Shareholders’ Equity” to the Consolidated Financial Statements). In addition, the Company has been informed that in 2004 CCM, LLC (a related party of CCP III) distributed or sold 100,000 shares of the Company’s common stock that it had previously acquired in a separate partnership with similar objectives of investing in the insurance industry.
On March 31, 2003, the Company sold 2,453,310 shares of Series A Mandatory Convertible Preferred Stock (“the preferred shares”) to HCC. The preferred shares pay a 7 percent dividend on a quarterly basis. The dividend is cumulative, and is payable when declared by the Board of Directors. As of December 31, 2004, dividends of $2.1 million were declared, with $0.5 million being accrued and payable as of December 31, 2004 for all the preferred shares outstanding. In conjunction with the sale of the preferred, the Company agreed to reimburse HCC for certain fees related to the purchase of the stock. During 2004, the Company reimbursed HCC $0.2 million for these fees.
On March 12, 2003, the Company entered into a reinsurance consulting agreement with Rattner Mackenzie (Bermuda) Ltd., a wholly owned subsidiary of HCC, pursuant to which Rattner Mackenzie provides reinsurance consulting advice to the Company’s insurance subsidiaries for an annual fee of $250,000. The agreement expires on March 31, 2007.
During 2004, HCC, through its investment in the preferred shares and the Company’s common stock, owned approximately 10.7% of the Company on a fully diluted basis. In December 2004, HCC reduced its investment in the Company’s common stock and currently owns approximately 9.7% of the Company on a fully diluted basis.
The Company’s estimated contractual obligations and commitments as of December 31, 2004 were as follows:
(3) Claim payments do not have a contractual maturity date; exact timing of claim payments cannot be predicted with certainty. The above table estimates timing of claim payments based on historical payment patterns and excludes the benefit of reinsurance recoveries.
(4) 7% dividend on convertible preferred stock. Obligation calculated assuming preferred stock will convert on 10 year anniversary date.
The discussion of the adoption and pending adoption of recently issued accounting policies is included in note 1 - “Business and Significant Accounting Policies” in the Notes to the Consolidated Financial Statements, included in Item 8 “Financial Statements and Supplementary Data” on page 37.
Reserves for Losses and Loss Adjustment Expenses. The Company establishes reserves for the estimated total unpaid costs of losses and loss adjustment expense, which cover events that occurred in 2004 and prior. These reserves reflect the best estimates of the total cost of claims that have been incurred, but not yet paid and claims that have been incurred, but not yet reported. The process of establishing loss reserves is complex and imprecise as it reflects significant judgmental factors, such as past loss experience, current claim trends and the prevailing social, economic and legal environments. Additional uncertainties exist due to the growth in new business and the impact this growth has in determining loss reserves. Reserves are established for claims that have been incurred but have not been reported based on actuarial estimates.
The Company utilizes a variety of actuarial techniques and methods to determine the ultimate losses and loss adjustment expenses. Methods used include the paid loss development method, incurred loss development method, Bornhuetter-Ferguson method, loss ratio method, report year method and claim count development method. The combination of the methods produces a point estimate for each line of business, which the Company records as management’s best estimate given the available facts at that point in time. Each business segment is analyzed individually. The Company primarily uses internal data in the analysis, however, industry data is used where credibility of internal data is low and in the development of certain factors. The Company analyzes loss reserves on a quarterly basis. In addition to internal Company reserve studies, an independent actuary reviews the risk management reserves on a quarterly basis. A study of reserves by the Company’s consulting actuary for the run-off lines is conducted annually using additional actuarial methods.
Management believes that the aggregate loss reserves at December 31, 2004 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. In establishing these reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts and the legislatures in the recent past and the possibility of similar interpretations in the future, particularly with regard to asbestos and environmental claims, additional loss reserves may develop in future periods. These potential increases cannot be reasonably estimated at the present time. Any increases could have an adverse impact on future operating results, liquidity, risk-based capital ratios and the ratings assigned to the insurance subsidiaries by the nationally recognized insurance rating agencies.
Goodwill. Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. As required by SFAS No. 142, “Goodwill and Other Intangible Assets”, the Company assigned goodwill to its reporting units. As of December 31, 2004, the Company has $48.5 million of goodwill allocated to the excess and surplus lines segment, $27.1 million of goodwill assigned to the risk management segment, $29.8 million assigned to the specialty commercial segment and $0.9 million of goodwill allocated to the public entity segment. As required by SFAS No. 142, the Company completed its annual test of goodwill for impairment as of September 30, 2004 and determined that no impairment of goodwill was indicated. Annually, the Company will perform an impairment of goodwill test. If impairment indicators exist between the annual testing periods, management will perform an impairment of goodwill test to determine if the fair value of the reporting unit is below the carrying value and therefore, requires a write-down of goodwill for that reporting unit. In evaluating whether impairment exists in certain reporting units, management also considers the fair value in excess of the carrying value for certain assets.