The table shown below presents selected financial data for each of the five years ended December 31, 2004. This financial information was prepared in accordance with GAAP. The GAAP statement of operations data for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 and the GAAP balance sheet data at December 31, 2004, 2003, 2002, 2001 and 2000 were derived from Crum & Forster Holdings Corp.’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated balance sheets at December 31, 2004 and 2003, and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows for each of the three years ended December 31, 2004, and accompanying notes, appear in “Item 8. Financial Statements and Supplementary Data”. The combined statutory data has been derived from annual statutory financial statements, which have been filed with the domiciliary states of the Company’s insurance subsidiaries, and prepared in accordance with SAP, which differs from GAAP.
The selected financial data presented below should be read in conjunction with “
The following discussion and analysis should be read in conjunction with Crum & Forster’s consolidated financial statements and accompanying notes included in “Item 8. Financial Statements and Supplementary Data”. Certain information constitutes forward-looking statements that involve risks and uncertainties. For further discussion of forward-looking statements, see page 4. Actual results may differ materially from the results discussed in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Item 1. Business - Risk Factors”.
IBNR reserves are calculated by the Company’s actuaries using several standard actuarial methodologies, including paid and incurred loss development, the Bornheutter-Ferguson loss methods, the Berquist-Sherman loss methods and frequency and severity approaches. The Company’s actuaries utilize assumptions in determining their estimates. These assumptions include loss development factors, loss ratios, reported claim frequency and severity. The selected assumptions reflect the actuary’s judgment based on historical data and experience. Most IBNR loss reserves are established with respect to the Company’s casualty business. Casualty business generally has a longer tail (meaning a longer period of time between the occurrence of the covered event and the ultimate settlement of the claim) than the Company’s other lines of business. Because many of the types of coverage offered by the Company involve claims that may not ultimately be settled for many years after they are incurred, subjective judgments as to the ultimate exposure to losses are an integral and necessary component of the loss reserving process.
The Company’s actuaries also conduct an internal ground-up study of asbestos and environmental reserves every six months. Ground-up studies, which the Company conducts semi-annually, involve an insured-by-insured evaluation considering the following factors: available insurance coverage, including the role of any umbrella or excess insurance issued to the insured; limits, deductibles and self-insured retentions; an analysis of each insured’s potential liability; the jurisdictions involved; past and anticipated future asbestos claim filings against the insured; loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expenses; the potential role of other insurance; and applicable coverage defenses. The evaluations are based on current trends without any assumption of potentially favorable or unfavorable legislation in the future. In 2004, based on the Company's internal actuarial review and an independent actuarial firm's ground-up study of asbestos reserves, the Company strengthened its asbestos reserves by $90.5 million. The independent actuaries last performed an independent ground-up study of the Company’s asbestos reserves in 1996.
Losses and LAE are charged to income as they are incurred. This includes loss and LAE payments and any changes in reported case and IBNR reserves. During the loss settlement period, reserves established in prior years are adjusted as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in the Company’s financial results in the periods in which they are made, and are referred to as prior period development. Due to this high level of uncertainty, revisions to these estimated reserves could have a material impact on the Company’s results of operations in the period recognized, and ultimate actual payments for claims and LAE could turn out to be significantly different from estimates.
The Company has written general liability, commercial multi-peril and umbrella policies under which its policyholders continue to present asbestos, environmental and other latent claims. The vast majority of these claims are presented under policies written many years ago. There are significant uncertainties in estimating the amount of reserves required for asbestos, environmental and other latent exposure claims. Reserves for these exposures cannot be estimated solely with the traditional loss reserving techniques described above, which rely on historical accident year development factors and take into consideration the previously mentioned variables. Among the uncertainties relating to asbestos, environmental and other latent reserves are a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different, and frequently inconsistent, conclusions as to when losses occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted.
Early asbestos claims focused on manufacturers and distributors of asbestos-containing products. Thus, the claims at issue largely arose out of the products hazard and typically fell within the policies’ aggregate limits of liability. Increasingly, insureds have been asserting that their asbestos claims are not subject to these aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence, potentially creating even greater exposure for primary insurers. Generally, insureds who assert these positions are installers of asbestos products or property owners who allegedly had asbestos on their property. In addition, in an effort to seek additional insurance coverage, some insureds that have eroded their aggregate limits are submitting new asbestos claims as “non-product” claims or attempting to reclassify previously resolved claims as non-product claims. Unlike product exposures, these non-product exposures are argued not to be subject to aggregate limits, creating potentially greater exposure. The extent to which insureds will be successful in obtaining coverage on this basis is uncertain and, accordingly, it is difficult to predict the ultimate size of the claims for coverage not subject to aggregate limits.
Hazardous waste sites present another significant potential exposure. The federal “Superfund” law and comparable state statutes govern the cleanup and restoration of toxic waste sites and formalize the concept of legal liability for cleanup and restoration by PRPs. These laws establish the means to pay for cleanup of waste sites if PRPs fail to do so, and to assign liability to PRPs. Most PRPs named to date are parties who have been generators, transporters, past or present landowners or past or present site operators. Most sites have multiple PRPs. Most insurance policies issued to PRPs did not expressly cover the costs of pollution cleanup since pollution was not a recognized hazard at the time many of these policies were issued. Over time, judicial interpretations in many cases have found that the scope of coverage of the policies included pollution exposure. Since 1986, however, most general liability policies exclude coverage for such exposures.
In addition to asbestos and environmental pollution, the Company faces exposure to other types of mass tort claims. These other latent claims include those associated with silica, chemicals, lead, sick building syndrome, gas and vapors, repetitive stress, paint and mold.
For the years ended December 31, 2004, 2003 and 2002, the Company has recognized adverse development of prior years’ losses and LAE, before the benefit of corporate aggregate reinsurance, of $97.6 million, $132.2 million and $26.6 million, respectively. Substantially all of such development was attributable to asbestos reserves. Due to the inherent uncertainties in estimating reserves for unpaid losses and LAE described above, and to the potential impact of recent trends, the ultimate liability for the Company’s loss and LAE reserves, and, in particular, its asbestos, environmental and other latent claims reserves, may vary substantially from the amounts currently reserved.
For additional discussion on the Company’s reserves, see “Item 1. Business-Reserves” and Notes 5 and 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Declines in the market value of invested assets below carrying value are evaluated for other than temporary impairment losses on a quarterly basis. Management considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time is outweighed by evidence to the contrary. Recognition of impairment losses for declines in the value of fixed income investments and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, current and expected future market and economic conditions, the impact of issuer-specific events, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price. For fixed income investments with unrealized losses due to market conditions or industry-related events, management also considers the Company’s ability and intent to hold the investment for a period of time sufficient to allow a market recovery, or to maturity, in the process of evaluating whether a security with an unrealized loss has suffered an other than temporary decline.
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include significant subsequent changes in general economic conditions, as well as specific business conditions affecting particular issuers, subjective assessment of issuer-specific factors (seniority of claims, collateral value, etc.), future financial market effects, stability of foreign governments and economies, future rating agency actions and significant disclosure, accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment are involved in determining if a decline is other than temporary. If management determines that a decline in fair value is not other than temporary and, hence, a security’s value is not written down at that time, there are potential effects upon future earnings and financial position should management later conclude that some of the current declines in the fair value of the investments are other than temporary declines.
As of December 31, 2004 and 2003, reinsurance recoverable was $1,804.8 million and $1,680.5 million, net of reserves for uncollectible reinsurance of $40.9 million and $39.9 million, respectively. Bad debt expense for the years ended December 31, 2004, 2003 and 2002 related to uncollectible reinsurance was $5 million, $5.3 million and $0.6 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2004, the five largest gross reinsurance recoverable balances aggregated $1,128.9 million, or 62.5% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $499.8 million as of that date. The largest unsecured balance as of December 31, 2004 was $194.1 million, due from an unaffiliated company rated A+ by A.M. Best.
As of December 31, 2004, there are no valuation allowances against the Company’s deferred tax assets of $242.1 million. Should the assumptions of future profitability change, however, or the taxable income of these entities fall below expectations, a valuation allowance, which could be significant, may have to be established if management believes any portion of the deferred tax asset will not be realized. A valuation allowance may also be required if there is a material change in the tax laws such that the actual effective tax rate or the time periods within which the underlying temporary differences become taxable or deductible change.
Includes $40.7 million of gains in 2003 from the sale of Hub International Limited securities to an affiliate.
Net income rose to $135.7 million in 2003 from $82.9 million, excluding $64.8 million in 2002 related to the cumulative effect of a change in accounting principle pursuant to which the Company wrote off its unamortized negative goodwill balance. The improvement was principally the result of better investment results offset, in part, by a deterioration in underwriting results. Underwriting losses increased primarily as a result of adverse development of prior years’ loss and LAE reserves of $118 million, principally arising from asbestos exposures.
For the year ended December 31, 2004, gross premiums written in casualty lines, which include the workers’ compensation, general liability and commercial automobile lines of business, increased by $42.7 million, or 6.0%, as compared to the year ended December 31, 2003. This increase was primarily due to modest increases in pricing on renewal policies and in the renewal retention rate, partially offset by a reduction in new business. The renewal retention rate was negatively affected by increased competition and the discontinuance of certain business programs accounting for approximately $17.7 million of gross premiums written in 2003.
California workers’ compensation gross premiums written totaled $156.1 million, $147 million and $74.2 million in 2004, 2003 and 2002, respectively.
For the year ended December 31, 2004, gross premiums written in property lines, which include the property, commercial multi-peril and surety lines of business, decreased by $7.9 million, or 2.0%, as compared to the year ended December 31, 2003. This decrease was primarily due to reductions in new business and price decreases on renewal policies, partially offset by an increase in the renewal retention rate. Property production was affected by softening market conditions, characterized by increased capacity in the marketplace and decreasing rates.
For the year ended December 31, 2003, gross premiums written in property lines increased by $47.2 million, or 13.7%, as compared to the year ended December 31, 2002. This increase was primarily due to an increase in renewal retention levels in the property business line.
The adverse development before corporate aggregate reinsurance in calendar year 2004 of $97.6 million (10.7 percentage points) was primarily due to deficiencies in asbestos reserves of $90.5 million, principally recorded in the fourth quarter following the Company’s internal actuarial review and an independent actuarial firm’s ground-up study of such reserves. As previously noted, there has been an industry-wide deterioration in asbestos liabilities caused by increases in the number of claimants filing asbestos claims and attorneys targeting new and previously peripheral defendants, including some of the Company’s insureds. Additionally, environmental reserves were strengthened by $10 million in the fourth quarter of 2004. Asbestos and environmental reserves arise principally from general liability policies written in accident years prior to 1998. The Company also recognized favorable development of $37.5 million for accident year 2003, primarily in property and workers’ compensation and $30.7 million in 1998 and prior, principally in non-latent general liability. This was largely offset by unfavorable non-latent development of $68.8 million for accident years 1999 and 2000, principally in the workers’ compensation and general liability lines.
Cessions to prospective corporate aggregate reinsurance in 2003 of $1.1 million includes the benefit of cessions to the 2001 accident year treaty with nSpire, an affiliate of the Company, of $55.1 million, partially offset by charges of $54 million associated with the commutation of two prospective corporate aggregate reinsurance contracts. The commutation charge of $54 million included $27.2 million arising from the commutation of the aforementioned accident year 2001 treaty with nSpire and $26.8 million related to commutation of a contract with an unrelated party covering accident years 1992 and prior.
Accident year loss and LAE ratios, as estimated at December 31, 2004 by line of business, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are summarized as follows:
Underwriting expenses are comprised of policy acquisition costs and other underwriting expenses. Policy acquisition costs are comprised principally of commissions paid to producers and premium taxes. Other underwriting expenses consist of all other operating expenses associated with the Company’s underwriting activities, including salaries and benefits, information technology and rent. The Company’s underwriting expense ratio has trended downward, decreasing from 31.9% in 2002 to 27.9% in 2004, which was primarily attributable to premium growth rates which exceeded the Company’s expense growth rate.
The Company manages its investment portfolio with an emphasis on total return. Total rate of return was 6.5%, 13.7% and 13.6% for the years ended December 31, 2004, 2003 and 2002. The decrease in the Company’s total investment return in 2004 primarily reflected the favorable effect of the significant rally in U.S. Treasury bonds in 2003, compared to a moderate weakening of the bond market in 2004. Investment income was $85.1 million, $69.9 million and $113.8 million in 2004, 2003 and 2002, respectively. In 2004, the increase in investment income of $15.2 million, or 21.7%, was due to the combined effects of the reinvestment of cash balances into longer-duration fixed income securities and higher earnings from equity method investees, partially offset by interest charges relating to higher funds held under reinsurance contracts. The decrease in investment income in 2003 of $43.9 million, or 38.6%, from 2002 was primarily the result of lower investment yields caused by the change in investment mix within the Company’s portfolio. The proceeds from realized investment gains of $268.2 million in 2003 were held in historically low-yielding short-term investments, pending long-term reinvestment, which occurred in 2004. The net investment yield over the three-year period was also affected by interest charged on funds held from reinsurers under reinsurance contracts. Funds held from reinsurers on reinsurance contracts increased as the result of additional losses ceded under such contracts during 2004. For further discussion of investment income, see Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Interest and other expense (income) were $41.6 million, $24.6 million and $(16.1) million in 2004, 2003 and 2002, respectively. Interest expense on the Company’s 10-3/8% senior notes issued in June 2003 increased to $33.2 million in 2004 from $18.7 million in 2003.
Interest and other expense (income) in 2002 was principally composed of an $18.4 million gain recognized in conjunction with the termination of the lease on the Company’s home office in Morristown, NJ, related to a fair value rent adjustment recorded at the date the Company was acquired by Fairfax. The Company entered into a new lease arrangement effective December 31, 2002.
As a holding company with no direct operations, Crum & Forster Holdings Corp.’s assets consist primarily of its investments in the capital stock of its insurance subsidiaries, $16.2 million of restricted cash and investments held in an interest escrow account for the next interest payment on the Company’s senior notes and deferred tax assets associated with holding company net operating losses. The Company requires cash to meet its annual debt service obligations (approximately $31.1 million per annum), to pay corporate expenses and, ultimately, to repay the $300 million aggregate principal amount of senior notes due 2013. Crum & Forster’s ability to satisfy its corporate obligations is primarily dependent on the dividend paying capacity of its subsidiaries. State insurance laws restrict the amount of shareholder dividends that insurance companies may pay without prior approval of regulatory authorities. For a detailed discussion of shareholder dividend regulations, see “Item 1. Business-Insurance Regulatory Matters”.
On June 5, 2003, Crum & Forster Funding Corp. issued $300 million aggregate principal amount of 10-3/8% senior notes due 2013. Crum & Forster Funding Corp. was a Delaware corporation formed by Policy Inc., an unaffiliated third party, as a special purpose entity, solely for the purpose of issuing 10-3/8% senior notes due 2013. On June 30, 2003, Crum & Forster assumed all of Crum & Forster Funding Corp.’s outstanding obligations under such notes and the indenture governing such notes. These notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $291 million were used to fund an interest escrow account of approximately $63.1 million to make the first four semi-annual interest payments on the notes and to pay a dividend to Fairfax in the amount of $217.9 million, with the remainder used to pay certain financing costs. Under the terms of the Company’s senior notes, the Company has significant restrictions on the amount of new debt that may be incurred.
The agreements governing the bank credit facilities of Fairfax contain restrictive covenants prohibiting Fairfax, with certain exceptions, from allowing Crum & Forster to borrow money, encumber its property or assets, acquire or attempt to acquire direct or indirect control of another person or asset where the acquisition is being contested or resisted, effect a reorganization, consolidation, merger, amalgamation or other business combination with any person other than a wholly-owned subsidiary of either Crum & Forster or Fairfax, dispose of property or assets other than in a bona fide disposition for fair value to an arm’s length third party or to Fairfax or one of its wholly-owned subsidiaries or enter into any agreements that limit the amount of dividends or management fees payable by the Company to Fairfax. Although Crum & Forster is not a party to the Fairfax credit facilities, it is expected, and should be assumed, that Fairfax will not permit Crum & Forster to borrow additional funds unless it is permitted to do so pursuant to the Fairfax credit facility. This affects the Company’s ability to incur debt pursuant to bank loans or raise funds in the capital markets.
Shareholder’s equity was $881.2 million at December 31, 2004, as compared to $906.1 million at December 31, 2003. The decrease was primarily the result of dividends paid to Fairfax, partially offset by current year earnings and increased net unrealized investment gains during 2004.
In July 2004, the Company pledged cash and U.S. Treasury securities as collateral for the Company’s obligation to purchase SPDRs (see “-Investment Results”). At December 31, 2004, the fair value of such collateral was $277.9 million. On January 21, 2005, the Company changed the custodian of these assets to satisfy state regulatory requirements. The new custodian required that the collateral be increased to approximately $327 million.
The aggregate carrying value of the Company’s investment portfolio, including cash and cash equivalents, was $3.2 billion, $3.2 billion and $2.4 billion at December 31, 2004, 2003 and 2002, respectively. The increase in invested assets in 2003 of $0.8 billion was partially the result of operating cash flows of $387.5 million in 2003. Favorable market movements in the fixed income and equity securities portfolio also contributed to the increase in invested assets. For detailed information on the Company’s investment portfolio, see Note 4 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
US Fire, North River, CF Indemnity and CF Insurance have each entered into master securities repurchase agreements that allow these companies to raise funds through repurchase arrangements with Fairfax. Under these agreements, US Fire and North River may raise a maximum of $100 million at any one time and CF Indemnity and CF Insurance are limited to $5 million each. These arrangements have not been utilized since 2000.
The Company’s combined statutory policyholders’ surplus was $1,206.5 million at December 31, 2004, as compared to $1,107.4 million at December 31, 2003. Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. Effective March 30, 2004, the State of Delaware enacted legislation to adopt certain insurance accounting standards promulgated by the NAIC. The adoption of such standards resulted in an increase in the Company’s combined statutory policyholders’ surplus of $28.1 million, principally relating to the recognition of goodwill. The increase in the Company’s combined statutory surplus was primarily attributable to statutory net income of $74.6 million and unrealized investment gains of $75.6 million, partially offset by a dividend payment of $80 million. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, remained relatively stable in 2004, 2003 and 2002 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios of 1.1x, 1.2x and 1.3x, respectively.
The Company has outstanding $300 million aggregate principal amount of 10-3/8% senior notes due 2013. Interest payments on such notes are approximately $31.1 million per year. For additional information on the Company’s senior notes, see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and -Liquidity and Capital Resources-Holding Company”.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. The amounts above represent the minimum contractual rentals for such operating leases as of December 31, 2004. For more information on the Company’s operating leases, see Note 12 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Included in other contractual obligations are expected contributions to health care and life insurance benefit plans sponsored by the Company, payments under certain incentive and bonus plans and payments under an information technology services agreement.
The Company’s obligation on the information technology services agreement was taken without consideration of renewal provisions. For additional information on this agreement, see Note 12 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows present fairly, in all material respects, the financial position of Crum & Forster Holdings Corp., an indirect wholly-owned subsidiary of Fairfax Financial Holdings Limited, and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. 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 audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform our audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The notes are an integral part of the consolidated financial statements.
Crum & Forster Holdings Corp. (the “Company” or “Crum & Forster”) is a Delaware holding company, which is 100% owned by Fairfax Inc., a Wyoming holding company. Fairfax Inc. is wholly owned by FFHL Group Ltd., a Canadian holding company, which is owned by Fairfax Financial Holdings Limited (“Fairfax”), a Canadian financial services holding company, which is publicly traded on the Toronto Stock Exchange and on the New York Stock Exchange under the symbol “FFH”. The Company, through its subsidiaries, provides a full range of commercial property and casualty insurance distributed through an independent producer force located across the United States.
These consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of the Company, Holding and their wholly-owned subsidiaries, including United States Fire Insurance Company (“US Fire”), The North River Insurance Company (“North River”), Crum & Forster Indemnity Company (“CF Indemnity”), Crum and Forster Insurance Company (“CF Insurance”) and Crum & Forster Underwriters Co. of Ohio (“CF Underwriters”). Effective July 1, 2004, CF Underwriters was merged into US Fire. US Fire owns 100% of the stock of Crum & Forster Specialty Insurance Company. North River owns 100% of the stock of Seneca Insurance Company, Inc. and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Such estimates and assumptions may differ from actual results. Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2004 presentation.
The Company considers highly liquid investments purchased with a maturity of three months or less to be cash equivalents.
Goodwill is subject to an assessment of impairment on an annual basis, or more frequently under certain circumstances. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed, followed by a measurement of the impairment, if any. Impairments are charged to operations in the period in which the impairment occurs. The Company’s annual impairment test in 2004 and 2003 resulted in a conclusion that no goodwill impairment has occurred. Goodwill is included in other assets on the consolidated balance sheets.
The Company maintains a reserve for uncollectible loss deductibles. This reserve includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. As of December 31, 2004 and 2003, the amount of the reserve was $5,738 and $10,960, respectively.
The Company reinsures, in the ordinary course of business, certain risks with other insurance and reinsurance companies (“reinsurers”). These arrangements provide the means for greater diversification of business and serve to limit the net loss potential of unusually severe or frequent losses. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder; however, the reinsurer that accepts the risk assumes an obligation to the original insurer. The ceding insurer retains a contingent liability with respect to reinsurance ceded to the extent that any reinsuring company might not be able, or willing, to meet its obligations. Reinsurance recoverable includes the balances due from reinsurers for paid and unpaid losses and LAE that are expected to be recovered from reinsurers. Reserves for uncollectible reinsurance are determined based upon regular reviews of the financial condition of reinsurers and assessments of other available information. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the ceded contracts.
For retroactive reinsurance contracts, the excess of reinsurance recoverable due from reinsurers pursuant to the contracts over premiums paid for such reinsurance coverage is deferred and amortized as a reduction to losses and LAE over the expected period of recovery using the interest method.
Premiums withheld from reinsurers pursuant to the related reinsurance contracts are included in funds held under reinsurance contracts on the consolidated balance sheets. Interest accrues on these funds in accordance with the contract terms and is included as a reduction to investment income on the consolidated statements of income. Interest on funds held under reinsurance contracts is charged at rates between 7.0% and 7.5% per annum as specified in the related reinsurance contract.
The Company participates in tax sharing agreements that provide for the inclusion of the Company in the consolidated federal income tax returns of Fairfax Inc. (the “Fairfax Group”), as well as the consolidated or combined state income or franchise tax returns of Fairfax Inc. Subject to the tax sharing agreements discussed in this paragraph, every member of the Fairfax Group is severally liable for the federal income tax liabilities of the Fairfax Group, and may be liable under similar rules for state income or franchise taxes of the entire group. Under the tax sharing agreements, Crum & Forster and its insurance subsidiaries make payments to Fairfax Inc. equal to the amounts of federal income taxes that each company would pay, subject to some adjustments, if they each had filed their own separate federal income tax returns, and their shares of any state income or franchise taxes. Thus, although the Company cannot currently offset its losses (including amounts arising from interest expense on its senior notes) or losses of one of its subsidiaries against income of another in computing the federal income tax payments to Fairfax Inc. under the tax sharing agreements, Fairfax Inc. has agreed to amend the tax sharing agreements at such time and in such a way as to permit the Company to utilize the holding company net operating losses prior to their expiration.
Deferred income taxes are provided for temporary differences between the financial statement and tax bases of assets and liabilities. Such differences relate principally to deferred income on retroactive reinsurance, unpaid losses and LAE, unearned premiums, net operating loss carryforwards, unrealized net appreciation of investments, deferred policy acquisition costs and deferred benefit plan payments. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion of, the benefits related to deferred tax assets will not be realized.
Insurance premiums are earned ratably over the terms of the related policies after deductions for premiums ceded to reinsurers. Unearned premium reserves are established for the unexpired portion of policy premiums. Premiums are accrued for retrospectively rated policies and on policies subject to audit based on estimates throughout the contract or policy term. The reserve for uncollectible premiums includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. As of December 31, 2004 and 2003, the amount of the reserve was $23,859 and $22,359, respectively.
Financial statements of foreign investees accounted for using the equity method are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation”. Under SFAS No. 52, investments in entities accounted for under the equity method are translated into U.S. dollars at the rate of exchange in effect at the date of the transaction and related equity earnings are translated at the average rate in effect during this period. At each balance sheet date, the carrying amounts are translated into U.S. dollars at the rate in effect at the balance sheet date and any translation gains or losses are recorded in other comprehensive income.
In June 2001, the Financial Accounting Standards Board issued SFAS No. 142, “Goodwill and Other Intangible Assets”, which addresses accounting and reporting for intangible assets. SFAS 142 eliminated the requirement for systematic amortization and instead imposes impairment testing, at least annually, to determine whether the fair value of the reporting unit to which the goodwill is ascribed supports its continued recognition. The acquisition of the Company by Fairfax in 1998 resulted in the recognition of negative goodwill as a result of net assets acquired in excess of the purchase price of $97,800. Under SFAS No. 142, the remaining unamortized negative goodwill of $64,809 at December 31, 2001 was recognized as a cumulative effect of a change in accounting principle on the consolidated statement of income in 2002.
The aggregate carrying value of the Company’s investment portfolio was $3,217,610 and $3,168,389 at December 31, 2004 and 2003, respectively, and is comprised of available-for-sale securities, other invested assets and cash and cash equivalents.
Investments in available-for-sale fixed income and equity securities are summarized as below:
At December 31, 2004, no securities in the Company’s equity portfolio had gross unrealized losses attributable to securities in a loss position for greater than 12 consecutive months. Four equity securities had gross unrealized losses totaling $19,454, which exceeded 10% of their cost at December 31, 2004. The majority of the $19,454 loss was attributable to one equity security in the pharmaceutical industry.
The contractual maturity of the Company’s fixed income securities with unrealized losses is summarized as follows:
The components of investment income for the years ended December 31, 2004, 2003 and 2002 are summarized as follows:
Income on other invested assets includes earnings of investment companies and similar equity method investees of $5,205, $11,229 and $9,939 in 2004, 2003 and 2002, respectively, and other interest income. Pre-tax earnings of other equity method investees was $19,197 and $2,411 in 2004 and 2003, respectively. There were no earnings from other equity method investees in 2002. Interest on funds held under reinsurance contracts is charged at rates between 7.0% and 7.5% per annum, as specified in the related reinsurance contract.
Included in realized investment losses from other invested assets for the year ended December 31, 2004 is a net loss of $15,237 related to the change in fair value of short-sale obligations and related option contracts. These transactions are discussed further below. Included in realized investment losses for the years ended December 31, 2003 and 2002 is $13,846 and $275 respectively, related to losses on other than temporary impairments. No such impairments were recorded in 2004.
On November 15, 2004, the Company invested $10,000 in Pacific, a fund owned 100% by Fairfax affiliates, which invests primarily in Japanese equity securities. An additional $10,000 was invested in Pacific in January 2005.
On July 27, 2004, the Company sold 66,775 shares of Zenith common stock for total proceeds of $2,748, resulting in a realized investment gain of $1,030.
On June 29, 2004, the Company sold two million shares of Russel common stock for total proceeds of $15,590, resulting in a realized investment gain of $9,930.
In December 2003, the Company acquired 800,000 shares of the common stock of Odyssey from TIG Insurance Company (“TIG”), a wholly-owned subsidiary of Fairfax. Odyssey is a publicly traded reinsurance company (NYSE:ORH) owned 80.9% by Fairfax and affiliates. The purchase was made at $22.28 per share, which approximated the fair market value on the date of purchase. The total cost of the Odyssey shares was $17,824 and market value as of December 31, 2004 was $20,168.
In May 2003, the Company acquired approximately 7.8 million shares of the common stock of Northbridge, a subsidiary of Fairfax that completed an initial public offering of its common stock in Canada (TO:NB), in exchange for common stock and debentures of Hub International Limited (“Hub”) held by the Company. The fair value of the Hub investments held by the Company at the date of the transaction, or $83,873, exceeded the Company’s acquired interest in the net assets of Northbridge by $8,818, which was recorded as an adjustment to the Company’s additional paid-in capital. The disposal of the Hub investments resulted in a realized gain of $40,725, which was included in realized investment gains in the consolidated statement of income for the year ended December 31, 2003. As of December 31, 2004, the market value of the Northbridge shares was $188,962.
The difference between the Company’s aggregate share of shareholders’ equity or partners’ capital and the carrying value on the consolidated balance sheets is
primarily due to goodwill arising on the acquisition of the investees.
The Company holds a 16.5% interest in HWIC at December 31, 2004. For the years ended December 31, 2004, 2003 and 2002, pre-tax equity in earnings of HWIC were $2,223, $14,059 and $7,957, respectively, and was included in investment income on the consolidated statements of income. No dividends have been received from HWIC.
As of December 31, 2004, the fair value of the Company’s derivative contracts was $13,069, including the Options discussed above. For the years ended December 31, 2004 and 2003, the Company recorded net losses of $1,373 and $2,709, respectively in realized investment gains as a result of changes in the fair value of derivative contracts.
Fixed income securities and cash and cash equivalents of $292,408 and $171,812 were on deposit with various state regulatory authorities as of December 31, 2004 and 2003, respectively, as required by insurance laws.
In conjunction with the issuance of the Company’s $300,000 aggregate principal amount of 10-3/8% senior notes due 2013, Crum & Forster funded an interest escrow account in the amount of $63,115. As of December 31, 2004, the escrow account balance of $16,212 was principally invested in U.S. Treasury notes and is included in other assets on the consolidated balance sheets. The interest escrow is required to be maintained until the next interest payment on the senior notes is made in June 2005, after which time, in accordance with certain provisions in the indenture, the Company is no longer required to hold funds in escrow for payment of interest on its senior notes.
Equals additional premiums due on retrospectively rated insurance policies that inure to the benefit of the reinsurer.
In 2004, based on the Company’s internal actuarial review and an independent actuarial firm’s ground-up study of asbestos reserves, the Company strengthened its asbestos reserves by $90,515, principally in the general liability line. The reserve increase is consistent with an industry-wide deterioration in asbestos liabilities caused by increases in the number of claimants filing asbestos claims and attorneys targeting new and previously peripheral defendants, including some of the Company’s insureds. Additionally, the Company increased its environmental reserves by $10,007. These reserve increases were offset, in part, by $20,000 of reserve decreases primarily in the general liability line for accident years 1997 and prior.
In 2003, the Company strengthened its asbestos reserves by $149,835 based on its latest actuarial estimates. In addition, commutations of two reinsurance contracts resulted in a $53,968 charge to incurred losses and LAE related to prior years. These reserve increases were partially offset by favorable development of $34,919 for accident year 2002 and $47,592 for accident years 2000 and prior.
The Company also maintains reserves for other latent exposures such as those associated with silica, chemicals, lead, sick building syndrome, gas and vapors, repetitive stress, paint and mold. Changes in the Company’s liability for other latent exposures are summarized as follows:
The Company actively monitors and evaluates the financial condition of its reinsurers and prepares estimates of the uncollectible amounts due from reinsurers. Such estimates are made based on periodic evaluation of balances due from reinsurers, judgments regarding reinsurers’ solvency, known disputes, reporting characteristics of the underlying reinsured business, historical experience, current economic conditions and the state of reinsurer relations in general and with the Crum & Forster companies in particular. Management attempts to mitigate collection risk from reinsurers by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have credit ratings and statutory surplus above certain levels. Reinsurance recoverable on the consolidated balance sheets is stated net of reserves for uncollectible reinsurance of $40,930 and $39,882 at December 31, 2004 and 2003, respectively.
In December 2003, the Company commuted its Aggregate Excess of Loss Reinsurance Agreement with Ridge Reinsurance Limited (“Ridge Re”), an unaffiliated reinsurer. The agreement provided the Company with $233,750 of stop loss coverage related to accident years 1992 and prior. The limits provided under the agreement had been fully utilized since 1995. Upon commutation of this agreement, Crum & Forster received from Ridge Re the estimated present value of the ceded liability of approximately $206,975. The excess of the nominal ceded liabilities over the present value received of approximately $26,775 was recorded as a component of incurred losses and LAE on the consolidated statement of income.
The Company purchases reinsurance to limit its exposure to loss from any one claim or occurrence (“per risk reinsurance”), from aggregate loss experience for an accident year that exceeds an amount the Company is willing to accept and from adverse development of prior years’ loss and LAE reserves (the latter two types of reinsurance are referred to herein as “corporate aggregate reinsurance”, as distinct from the aforementioned “per risk reinsurance”). The Company’s corporate aggregate reinsurance contracts cover or covered, in varying amounts and on varying terms, accident years 2002 and prior and provide either current accident year protection or adverse development protection related to prior accident years. In general, contracts covering past insurable events, such as adverse loss development covers, are categorized as “retroactive reinsurance”, as opposed to contracts covering future insurable events, which are referred to as “prospective reinsurance”. Coverage under these contracts is generally triggered when the loss ratio for the subject period exceeds a specified level, or when reserves related to all periods prior to a certain date exceed a stated amount. The Company will recover ceded losses and LAE from its reinsurers as it settles the related claims, which may occur over several years. These contracts may provide for future payments to be made by Crum & Forster when it cedes losses under such policies and generally provide that interest expense is charged to the Company, for the benefit of the reinsurers, on any premiums withheld.
Amounts ceded under prospective contracts are recognized, as to premiums, as a reduction of premiums written and earned in the period in which premiums are ceded and, as to losses, as a reduction of incurred losses as the losses are ceded to the reinsurer. Under retroactive contracts, the excess of reinsurance recoverable due from reinsurers pursuant to the contract over premiums paid for coverage is deferred and amortized as a reduction to incurred losses over the expected period of recovery, generally many years, using the interest method. Under both prospective and retroactive contracts, funds held interest, if applicable, is recognized as a reduction of investment income in the period in which the interest is credited to the funds held account.
The effect of prospective and retroactive corporate aggregate reinsurance on components of the Company’s consolidated statements of income is summarized as follows:
As of December 31, 2004, reinsurance recoverable includes $444,047 and $455,508 related to prospective and retroactive corporate aggregate reinsurance contracts, respectively, of which $507,186 has been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income.
The Company entered into an aggregate stop loss agreement with an unaffiliated reinsurer covering accident year 2000, which provided coverage of $118,493 and has been fully utilized by the Company. Premiums and losses ceded pursuant to the contract were $7,595 and $9,994, respectively, in 2004 and there were no cessions to the contract in 2003 and 2002. Premium cessions prior to 2002 were $68,758. As of December 31, 2004 and 2003, the Company had reinsurance recoverable balances of $76,547 and $108,499, respectively, related to this agreement.
In 2001, the Company entered into adverse development contracts with two unaffiliated reinsurers. One treaty provides $400,000 of reinsurance coverage for accident years 2000 and prior. As of December 31, 2004, the Company had ceded cumulative losses of $371,011, which is comprised of $140,565 in 2004, $10,446 in 2003, $10,000 in 2002 and $210,000 in 2001, and paid premiums of $58,056, $3,656, $3,500 and $84,786 in 2004, 2003, 2002 and 2001, respectively, related to this contract. All of the $28,989 remaining coverage on this treaty is available for asbestos development. The second treaty provides $100,000 of coverage for accident periods prior to August 13, 1998. As of December 31, 2004, the Company had ceded cumulative losses of $65,249, which is comprised of $(22,888) in 2004 and $88,137 in 2003, and had a return of premium of $(1,539) in 2004 and paid premiums of $34,136 in 2003 under this contract. None of the $34,751 remaining coverage on this treaty is available for asbestos development. The premiums for both contracts are included in funds held under reinsurance contracts on the consolidated balance sheets. The arrangements described above are recorded as retroactive reinsurance, with reinsurance recoverable due from reinsurers in excess of premiums paid for the coverage reflected on the balance sheets as deferred income on retroactive reinsurance. Such deferred income is amortized based on the expected amount and timing of future recoveries, using the interest method. In 2004, 2003, 2002 and 2001, the Company amortized $18,324, $13,048, $8,332 and $1,924 of deferred income, respectively, which is included as a reduction to losses and LAE in the consolidated statements of income.
For additional information on reinsurance transactions with related parties, see Note 10. Related Party Transactions.
For the year ended December 31, 2004, interest expense on the Notes was $33,159, including additional interest described above, accretion of the discount on the Notes and amortization of related deferred financing costs. As of December 31, 2004, deferred financing costs in conjunction with the issuance of the Notes totaled $9,787 and were included in other assets on the consolidated balance sheet. These deferred financing costs are being amortized to interest expense on a straight-line basis over the ten-year duration of the Notes.
Income tax expense shown on the consolidated statements of income excludes $6,719 and $844 of deferred income taxes on equity in earnings of investees in 2004 and 2003, respectively. Total income tax expense in 2004, 2003 and 2002, inclusive of these amounts, was $11,235, $71,458 and $43,136, respectively, and the related effective tax rate was 31.7%, 34.5% and 34.2%, respectively.
The Company and its subsidiaries have entered into various reinsurance arrangements with affiliates. The approximate amounts by which income, expense, assets and liabilities are increased (decreased) in the accompanying consolidated financial statements, with respect to reinsurance assumed and ceded, are summarized as follows:
The Company entered into an aggregate stop loss agreement covering accident years 2000 through 2002. For accident years 2002 and 2001, nSpire is the direct reinsurer. Accident year 2000 was reinsured by a third party reinsurer that retroceded the liability to nSpire, which was exhausted at December 31, 2003. The Company received cash for the full amount of the 2000 accident year cover in 2004. The Company retains an ultimate net loss up to 70% of net premiums earned in 2002 and 73% in 2001. Accident years 2002 and 2001 are subject to a per-term maximum recovery of $96,272 and $94,195, respectively. Pursuant to the agreement, the Company ceded premiums of $32,091 and $31,398 for accident years 2002 and 2001, respectively. As of December 31, 2004 and 2003, no losses were ceded to nSpire under this contract for accident year 2002. During 2003, the Company ceded losses of $55,098 for accident year 2001, which exhausted the limit. In December 2003, the Company and nSpire commuted the 2001 accident year liabilities of $94,195. In connection with the commutation, Crum & Forster received the estimated present value of the ceded liability of approximately $67,002 from nSpire. The excess of the nominal ceded liabilities over the present value received of approximately $27,193 was recorded as a component of incurred losses and LAE on the consolidated statement of operations. As of December 31, 2003, $39,514 of the settlement amount was recorded as a receivable in other assets on the consolidated balance sheet and was received by the Company in January 2004.
In the normal course of business, the Company has several reinsurance agreements in effect with Odyssey and its subsidiaries, affiliates of Fairfax. Under these agreements, Odyssey participates on contracts covering substantially all reinsured lines of business. For the years ended December 31, 2004, 2003 and 2002, the Company ceded $7,247, $7,434 and $9,847, respectively, in premiums to Odyssey and had reinsurance recoverable of $20,118 and $15,904 at December 31, 2004 and 2003, respectively, on these reinsurance agreements.
Effective January 1, 2001, the Company entered into a reinsurance agreement with Lombard General Insurance Company of Canada (“Lombard”), an affiliate of Fairfax, under which the Company has agreed to reinsure 100% of the surety business of Lombard underwritten by the Company. The agreement provides for a 10% ceding commission. For the years ended December 31, 2004, 2003 and 2002, the Company assumed $788, $1,103 and $1,091, respectively, in premiums from Lombard. As of December 31, 2004 and 2003, the Company had $1,002 and $638 in reserves for this assumed business.
The Company has various facultative policies in the normal course of business in effect with RiverStone Insurance (UK) Ltd., an affiliate of Fairfax. No premiums were ceded to RiverStone Insurance (UK) Ltd. in 2004, 2003 and 2002. At December 31, 2004 and 2003, the Company had reinsurance recoverable of $26 and $27, respectively, on these policies.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $7,606, $7,506 and $6,672 for the years ended December 31, 2004, 2003 and 2002, respectively, and were included as investment expenses in the consolidated statements of income.
Under an agreement effective September 1, 2001, US Fire has agreed to obtain certain information technology services, including production and operations support and systems development, on a non-exclusive basis from Fairfax Information Technology Services, Inc. (“FITS”), a wholly-owned subsidiary of Fairfax. Payments for these services for the years ended December 31, 2004, 2003 and 2002 were $14,464, $15,089 and $13,536, respectively. Of such payments, $9,064, $7,346 and $7,262 were charged directly to expense for 2004, 2003 and 2002, respectively. The remaining $5,400, $7,743 and $6,274 related to ongoing systems development costs for 2004, 2003 and 2002, respectively. The Company expenses these costs over a five-year period, beginning on the date the development project is placed in service. In 2004, 2003 and 2002, $2,576, $2,577 and $1,319, respectively was charged to operations and approximately $16,318 and $13,494 was included in other assets for the years ended December 31, 2004 and 2003, respectively. In addition, FITS entered into an agreement with the Company effective January 1, 2001 pursuant to which FITS is provided certain management and general services by the Company. Under this agreement, $49 and $54 were billed by the Company for the years ended December 31, 2004 and 2003, respectively.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. Minimum annual rentals are summarized as follows:
The amounts above are reduced by space subleased to other companies in the aggregate amount of $1,852.
Effective December 31, 2002, the Company entered into a 20-year operating lease for its home office. This lease has total minimum lease payments remaining of $53,626, which are included in the amounts above. In conjunction with the termination of the existing lease, the Company recognized income of $18,409 in 2002 relating to a fair value rent adjustment recorded at the date the Company was acquired by Fairfax.
In the ordinary course of their business Crum & Forster’s subsidiaries receive claims asserting alleged injuries and damages from asbestos and other hazardous waste and toxic substances and are subject to related coverage litigation. The conditions surrounding the final resolution of these claims and the related litigation continue to change. Currently, it is not possible to predict judicial and legislative changes and their impact on the future development of asbestos and environmental claims and litigation. This trend will be affected by future court decisions and interpretations, as well as changes in applicable legislation and the possible implementation of a proposed federal compensation scheme for asbestos-related injuries. As a result of these uncertainties, additional liabilities may arise for amounts in excess of current reserves for asbestos, environmental and other latent exposures. These additional amounts, or a range of these additional amounts, cannot currently be reasonably estimated. As a result of these claims, management continually reviews required reserves and reinsurance recoverable. In each of these areas of exposure, the Company litigates individual cases when appropriate and endeavors to settle other claims on favorable terms.
The Company’s subsidiaries are involved in various lawsuits and arbitration proceedings arising in the ordinary course of business. While the outcome of such matters cannot be predicted with certainty, in the opinion of management, no such matter is likely to have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity. However, it should be noted that the frequency of large damage awards, including punitive damage awards that bear little or no relation to actual economic damages incurred by plaintiffs in some jurisdictions, continues to create the potential for an unpredictable judgment in any given matter.
This quarterly financial data is unaudited. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary to present fairly the results of operations for such periods, have been made for a fair presentation of the results shown.