The Company leases office space in San Antonio, Texas for its corporate headquarters and for certain support functions associated with Argonaut Insurance. Other leased headquarters locations for the Company’s operating subsidiaries include offices in Richmond, Virginia (Colony), Rockwood, Pennsylvania, (Rockwood), Portland, Oregon, (Grocers Insurance), Chicago (Select Markets), and San Antonio, Texas (Trident). Argonaut Insurance owns its headquarters facility located in Menlo Park, California, and Great Central is headquartered in facilities it owns in Peoria, Illinois. In addition, the Company has entered into other leases in conjunction with its operations at various locations throughout the country. The Company believes that its properties are adequate for its present needs.
The following discussion should be read in conjunction with the consolidated financial statements and related notes on page 47. This discussion contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.
Hurricane Activity. During the years ended December 31, 2005 and 2004, several hurricanes made landfall, one of which (Hurricane Katrina during 2005) was one of the most devastating natural disasters in United States history. The Company has recorded its best estimate of losses and loss adjustment expenses for these events as of December 31, 2005, but continues to evaluate its losses. Due to the nature of the claims there are significant uncertainties inherent in the loss estimation process. Due to these significant uncertainties, there can be no assurance that future adverse loss development will not occur. The Company recorded losses and loss adjustment expenses related to these hurricanes, net of reinsurance, of $12.1 million and $17.7 million for the years ended December 31, 2005 and 2004, respectively. Additionally, reinstatement premiums related to the Company’s property catastrophe reinsurance program were $6.0 million and $1.8 million for these same periods. During 2005 the Company reviewed its estimate of the ultimate losses associated with the 2004 hurricane activity and reduced that estimate by $3.0 million. This change in estimate is included in loss and loss adjustment expenses for the year ended December 31, 2005.
Renewal Rights Acquisition. On April 1, 2005, the Company announced it had entered into an agreement with Fireman’s Fund Insurance Company to acquire the renewal rights and certain operating assets of the Binding Authority business segment, underwritten by Interstate Insurance Group, a subsidiary of Fireman’s Fund Insurance Company. Through Colony, the Company began offering policies to clients formerly with Interstate Insurance Group in the second quarter of 2005. For the year ended December 31, 2005, this renewal rights acquisition contributed $123.3 million in gross written premiums for the E & S segment. A portion of this business, primarily the commercial automobile coverage, was written on an admitted basis through Argonaut Insurance Company or one of its subsidiaries.
Renewal Rights Sale. The Company announced on August 29, 2005 that it sold the renewal rights to a substantial portion of its risk management business to XL America, Inc. (“XL”). Under the agreement, XL began offering renewal quotes to selected risk management clients beginning in September, 2005. In addition, customers renewing with XL continue to have access to claims management and loss control services through Argonaut Claims Services.
Reinsurance Commutations. In December 2005, the Company reached tentative agreement to commute certain reinsurance treaties with subsidiaries of Trenwick Group, Ltd., subject only to regulatory approval of the transactions. Under the terms of commutations, the Company will receive net cash payments of approximately $20.0 million in return for extinguishing all current and future liabilities between the parties under the treaties.
During the third quarter the Company estimated the impact of this and other potential commutations on its financial results and recorded a $10.0 million charge based on the likely range of circumstances under which such commutations could be accomplished. The $10.0 million was reflected in loss and loss adjustment expenses. In the fourth quarter of 2005 once the commutation agreement was executed, the Company reduced its allowance for doubtful accounts related to amounts due from reinsurers by $13.0 million. As of December 31, 2005 the Company has recorded as a receivable the $20.0 million referenced above.
Consolidated gross written premiums from renewal business were $468.4 million for 2005, compared to $469.9 million for 2004 and $333.8 million for 2003. Increases in the amount of business in force subject to renewal in 2005 were offset by the risk management renewal rights sale, previously discussed in Significant Events. The increase in premiums from renewal business in 2004 as compared to 2003 was primarily the result of an increase in the amount of business inforce subject to renewal.
The increase in earned premiums for all years presented was primarily attributable to the factors noted above. The percentage increase in earned premiums during 2005 compared to 2004 of 10.2% is slightly less than the percentage increase in gross written premiums due to: (a) the renewal rights acquisition in the second quarter of 2005 and subsequent earning of the written premium, (b) Argonaut Specialty also commenced writing business during the second quarter of 2005 and the subsequent earning of the written premium (c) the Select Markets segment wrote a large program account during the fourth quarter of 2005 that resulted in $18.4 million of gross written premium that will be earned over the next three quarters of 2006 and (d) earned premiums were reduced by $6.0 million for reinstatement premiums associated with the Property Cat reinsurance program.
Consolidated underwriting, acquisition and insurance costs were $262.5 million, $222.8 million and $191.0 million for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in the expense ratio during 2005 as compared to 2004 was primarily due to start up expenses related to a renewal rights acquisition effective April 2005 and the addition of Argonaut Specialty in the E & S segment as earned premium is not yet reflective of the amount of business in force. 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 Select Markets and Public Entity segments during the fourth quarter of 2003.
Interest expense was $15.0 million, $11.0 million and $8.4 for the years ended December 31, 2005, 2004 and 2003, respectively. Interest expense resulting from the junior subordinated debentures was $8.9 million in 2005, compared to $3.6 million and $0.6 million recorded in 2004 and 2003, respectively. During 2005, the Company issued an additional $30.9 million in junior subordinated debentures. Interest expense for funds withheld under a retroactive reinsurance contract totaled approximately $5.5 million, $6.9 million and $6.6 million for the years ended December 31, 2005, 2004 and 2003, respectively. The decrease in 2005 was due to the commutation of this contract during the third quarter of 2005, previously discussed in Significant Events. Interest expense for various other funds withheld by the insurance subsidiaries totaled $0.6 million, $0.5 million and $1.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The consolidated provision for income taxes for the year ended December 31, 2005 was $1.0 million, and includes tax expense of $26.5 million offset by the reversal of the remaining deferred tax valuation allowance of $25.1 million. The consolidated benefit for income taxes for the year ended December 31, 2004 was $11.1 million, and includes tax expense of $12.9 million, a reduction of the deferred tax valuation allowance of $24.0 million. During 2004, the Company reduced its liability for accrued taxes by $10.8 million due to the state of California enacting a law providing for a partial tax deduction for certain insurance company dividends received by a company subject to California corporate income tax. This reduction is included in the $12.9 million provision for income taxes for the year ended December 31, 2004. The consolidated provision for income taxes for the year ended December 31, 2003 was $26.3 million, including tax expense of $49.1 million and a reduction in the deferred tax asset valuation allowance of $22.8 million. The reduction of the deferred tax valuation allowance in 2005, 2004 and 2003 was based on management’s consideration of limited amounts of future income in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, “Accounting for Income Taxes” combined with earnings reported in those years.
As of December 31, 2005, the Company’s operations include four business segments: Excess and Surplus Lines, Select Markets, Public Entity and Risk Management. Additionally, the Company has one run-off segment for products it no longer underwrites. 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 evaluate its segments which excludes realized gains and losses on sales of investments.
The increase in earned premiums in 2005 as compared to 2004 and 2003 was primarily attributable to the same factors noted above with respect to gross written premiums, partially offset by reinsurance reinstatement premiums of $3.7 million.
Select Markets. This segment provides property and casualty coverages targeting specific groups of insureds and is underwritten by Great Central, Rockwood and Grocers Insurance. Great Central specializes in property insurance, liability insurance and workers’ compensation coverage in three broadly defined markets: food and hospitality, religious and other institutions, and specialty retail. Rockwood primarily provides workers’ compensation insurance for coal mines, other mining business and small commercial accounts. In addition, Rockwood provides supporting general liability, umbrella liability, property, commercial automobile and surety business, for certain of its mining accounts. In December 2003, the Company acquired the right to renew business underwritten by the Grocers Insurance segment of Royal and Sun Alliance USA. Grocers Insurance underwrites property, general liability, and workers’ compensation to privately owned independent grocers throughout the United States.
The increase in earned premiums was primarily attributable to the increases in gross written premiums for all years presented, partially offset by $1.8 million of reinsurance reinstatement premiums.
Losses and loss adjustment expenses for the year ended December 31, 2005 resulted in a loss ratio of 63.4% compared to 66.7% and 70.8% for 2004 and 2003, respectively. The decrease in the loss ratio for the year ended December 31, 2005 was primarily the result of refinement of the underwriting profile and improved terms and conditions. Included in losses and loss adjustment expenses for the year ended December 31, 2005, was $0.6 million in catastrophe losses resulting from the hurricanes that made landfall during the year. The decline in the loss ratio in 2004 was primarily attributable to a reduction in the catastrophe losses incurred from $2.1 million in 2003 to $1.1 million in 2004. Included in losses and loss adjustment expense for the year ended 2004 was $3.5 million of adverse development related to prior accident years. This development was primarily attributable to reserve strengthening as a result of the actuarial analysis completed in the fourth quarter of 2004 coupled with the impact of the reserve discount related to the workers’ compensation reserves. The Select Market segment’s loss reserves were $269.7 million, $215.7 million and $182.0 million as of December 31, 2005, 2004 and 2003, respectively.
Index to Financial Statements The following table summarizes the results of operations for the Public Entity segment:
The decrease in gross written premiums for the year ended December 31, 2005 as compared to 2004 was primarily the result of a decrease in new business written in 2005 as compared to 2004. For the year ended December 31, 2005, the Public Entity segment wrote $7.7 million in new business as compared to $34.2 million and $33.1 million for the same periods in 2004 and 2003, respectively. The decrease in the new business is a reflection of a change in distribution partners in several states, the increasingly competitive market and risk selection. Renewal business written by this segment was $59.3 million for the year ended December 31, 2005, as compared to $53.7 million and $29.4 million for the same periods in 2004 and 2003, respectively. The decrease in earned premiums for the year ended December 31, 2005, as compared to the same period in 2004, was primarily attributable to the lower premium writings in 2005 than 2004.
Losses and loss adjustment expenses for the year ended December 31, 2005 resulted in a loss ratio of 55.8% compared to 64.7% in 2004 and 63.3% for 2003. The decrease in the loss ratio in 2005 is primarily attributable to $3.8 million favorable development in both casualty and property business written in 2004 and prior. This prior year favorable development is net of $2.0 million of unfavorable development recorded in 2005 related to 2004 hurricane losses. Loss reserves for the Public Entity segment were $73.6 million, $60.0 million and $28.8 million as of December 31, 2005, 2004 and 2003, respectively.
The expense ratio for the year ended December 31, 2005 was 36.5% compared to 33.5% and 31.5% for the same periods of 2004 and 2003, respectively. The increase in the expense ratio in 2005 was primarily related to a $0.8 million regulatory windstorm assessment associated with the 2005 hurricanes, combined with higher catastrophe reinsurance reinstatement premiums recorded this year. The increase in the expense ratio in 2004 is primarily a result of higher acquisition costs associated with the 2003 renewal rights transaction.
The increase in net investment income was primarily attributable to higher invested balances due to positive cash flows as well as higher investment yields. Net invested assets were $116.5 million and $104.5 million as of December 31, 2005 and 2004, respectively.
Index to Financial Statements The following table summarizes the results of operations for the Risk Management segment:
The sale of the renewal rights, discussed previously under Significant Events, as well as heightened competition for loss sensitive business prior to the sale caused reduced gross written premium for the twelve months ended December 31, 2005. For the year ended 2005, renewal premiums accounted for $53.2 million of gross written premiums and new business accounted for $17.0 million of gross written premiums. Endorsements reduced gross written premiums by $1.7 million during 2005. Gross written premiums from renewal business were $92.3 million in 2004 and $53.1 million in 2003. Gross written premiums from new business were $40.2 million in 2004 and $57.0 million in 2003. Gross written premiums include $5.0 million in 2004 and $47.7 million in 2003 for certain product classes that the Company exited beginning in 2003.
Losses and loss adjustment expenses of $46.1 million, $71.9 million and $100.2 million for the years ended 2005, 2004 and 2003, respectively, equate to loss ratios of 60.1%, 62.1% and 81.9%. The improvement in the loss ratio over the three year period is the result of the Company re-underwriting this book of business with a focus on loss sensitive accounts. Loss sensitive large deductible and retrospectively rated policies have produced a better loss ratio than the products that the Company had previously written. Loss reserves for this segment were $626.5 million, $637.9 million and $653.7 million as of December 31, 2005, 2004 and 2003, respectively.
The Risk Management segment had $1.1 million of favorable development including $6.6 million of favorable development primarily driven by other liability losses from favorable trends on older accident years, offset by $5.5 million of unfavorable
Index to Financial Statements development in workers’ compensation. The unfavorable workers’ compensation development was driven by $8.0 million of reduced ceded losses from a reinsurance commutation with Trenwick America Reinsurance Corporation, partially offset by favorable development on involuntary pool losses. The Risk Management segment experienced favorable workers’ compensation development on the 2001 through 2004 accident years, which was largely offset by adverse development on older accident years.
Losses and loss adjustment expenses for the year ended 2004 were reduced by $5.3 million for favorable prior accident year development. Favorable development mainly attributable to the 2001, 2002 and 2003 accident years was partially offset by unfavorable development on accident years prior to 2001. 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, and $5.0 million related to an increase in the reinsurance allowance for doubtful accounts.
The expense ratio for the year ended 2005 was 55.0% versus 44.9% in 2004 and 49.9% in 2003. The increase in the expense ratio in 2005 is primarily caused by earned premium decreasing at a faster rate than costs to service the run off of this book of business. Expense management initiatives resulted in decreased levels of expenses in 2004 compared to 2003. Due to the loss sensitive nature of the business underwritten by Risk Management and premium rate reductions received by the insureds for assuming a portion of the risk, the expense ratio for this type business is higher than if the business were written on a guaranteed cost basis.
Index to Financial Statements 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, 2005. Amounts in the net column are reduced by reinsurance recoverables.
The following table represents the components of gross loss reserves for the run-off lines for each of the years in the three-year period ended December 31, 2005.
Annually the Company reviews its loss and loss adjustment expense reserves for its run-off lines of business, inclusive of its asbestos and environmental claims. The process is initiated at the end of the second quarter and is typically completed in the third quarter of the calendar year. The review entails a detailed analysis of the Company’s direct and assumed exposure. The Company engages a consulting actuary to provide its best estimate of ultimate losses and management evaluates that estimate in assessing the adequacy of the run-off loss and loss adjustment expense reserves. The review for 2005 was completed during the third quarter of 2005, and was updated in the fourth quarter. As a result of this analysis, the Company recorded an additional $0.1 million in reserves and the Company strengthened its unallocated loss adjustment expense reserves by $4.1 million based upon this analysis. Losses and loss adjustment expense for the year ended December 31, 2005 include a $2.0 million increase to the allowance for doubtful accounts related to certain reinsurance treaties from prior accident years. In
In 2004, the Company completed its analysis of the adequacy of loss and loss adjustment expense reserves for its run-off lines which include asbestos and environmental claims for its run-off lines. The review completed during the third quarter of 2004, and updated in the fourth quarter, indicated the carried reserves were adequate based on all information then available to the Company.
For the year ended December 31, 2003, the Company completed its analysis of the adequacy 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, 2005 were $183.6 million, net of reinsurance, including reserves for asbestos and environmental claims of $154.3 million. 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 $145.4 million to $256.6 million. In determining its best estimate, management primarily relied on the report year method, with some weight given to other methods. The report year method relies most heavily on the Company’s historical claims and severity information, whereas other methods rely more heavily on industry information. This method produces an estimate of losses which have been incurred but not yet reported based on projections of future claims and the average severity for those future claims. The severities were calculated based on the Company’s specific data and in management’s opinion best reflect the Company’s liabilities based upon the insurance policies issued. As a result of this reserve analysis, the reserve for incurred but not reported asbestos and environmental claims (net of reinsurance) at December 31, 2005, was $86.0 million compared to $89.4 million and $99.6 million as of December 31, 2004 and 2003, respectively. The reserve for incurred but not reported claims for the remaining run-off lines (net of reinsurance) was $12.0 million as of December 31, 2005, compared to $12.7 million and $11.8 million as of December 31, 2004 and 2003, respectively.
The following table represents a reconciliation of the number of asbestos and environmental claims outstanding for each of the years in the three-year period ended December 31, 2005.
The number of claims opened during the three years ended December 31, 2005 were from the following sources:
Included in the gross payments on closed claims in 2004 is a settlement relating to the Western MacArthur litigation. The Company, through its subsidiary Argonaut Insurance, was named in various legal actions filed by Western MacArthur Company, Western Asbestos Company (the “MacArthur Companies”) and certain other individual claimants. Argonaut Insurance’s involvement in these actions arose from nine construction wrap-up policies with an occurrence limit of $200,000 per policy issued to Western MacArthur Company and Western Asbestos Company, respectively, for liability arising out of work performed on five construction sites in the 1960’s and 1970’s. On April 14, 2004, the Bankruptcy Court presiding over the Chapter 11 Bankruptcy of the MacArthur Companies entered orders giving final approval to settlements reached with all property and casualty insurers of the MacArthur Companies currently in litigation, including Argonaut Insurance. A bankruptcy reorganization plan filed by the MacArthur Companies will be implemented and all existing and future claims against the MacArthur Companies related to asbestos will be channeled solely to a trust. Argonaut Insurance contributed $29.8 million into the bankruptcy trust and received a release from the MacArthur Companies as to any and all existing or future asbestos-related claims, including any claims for extra-contractual relief, arising directly or indirectly out of any alleged coverage under the nine Argonaut Insurance polices at issue. In addition, claimants seeking funds from the trust will be required to execute release and indemnity agreements in favor of Argonaut Insurance as a condition to receiving payment. The Company ceded the majority of its $29.8 million contribution to its reinsurers.
Net cash used by investing activities totaled $412.5 million, $245.8 million and $336.1 million for the years ended December 31, 2005, 2004 and 2003, 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, 2005, 2004 and 2003, $272.6 million, $112.4 million and $179.1 million, respectively, of the investment portfolio were invested in short-term, liquid investments.
In the first quarter of 2003, the Company sold certain parcels of real estate located in Southern California for approximately $64 million. During the year ended December 31, 2005, the Company received principal payments totaling approximately $19.7 million, including an $18.7 million payoff of one of the notes. As of December 31, 2005, the Company holds a note receivable on the remaining property of approximately $18.1 million, which is due and payable during 2006.
Net cash provided by financing activities totaled $79.5 million for the year ended December 31, 2005, and was primarily attributable to the Company’s issuance of common stock and junior subordinated debentures (see respective discussions below). For the year ended December 31, 2004, net cash provided by financing activities totaled $83.8 million, and was primarily attributable to the Company’s issuance of junior subordinated debentures. 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.
On October 5, 2005, the Company sold 1.4 million shares of its common stock, par value $0.10 per share, in an underwritten public offering. The common stock was issued at a price of $26.75 per share, less an underwriting discount of 4.3%. The net proceeds from the sale of the common stock were approximately $35.6 million, after deducting the underwriting discounts and commissions and offering expenses. The Company also granted the underwriters an option to purchase an additional 210,000 shares of common stock to cover over-allotments, which was exercised in full on October 31, 2005, resulting in net proceeds of $5.4 million.
During 2005, Argonaut Group Statutory Trust X (“Trust X”), a wholly owned subsidiary of the Company, sold 30,000 Floating Rate Capital Securities (liquidation amount $1,000 per Capital Security) in a private sale for $30.0 million. The statutory trust is not consolidated with the Company, as the primary beneficiaries are the investors of the floating rate securities. Trust X used the proceeds from this sale, together with the proceeds from its sale of 928 shares of Floating Rate Common Securities (liquidation amount $1,000 per Common Security) to the Company, to buy a series of Floating Rate Junior Subordinated Debentures due 2035 from the Company. The Debentures have the same payment terms as the Capital Securities.
On March 6, 2006, the Company entered into a Credit Agreement (the “New Credit Agreement”) with JPMorgan Chase Bank, N.A., as administrative agent, and the other lenders thereto. The New Credit Agreement replaced the Company’s 2004 Revolver Facility with LaSalle Bank National Association, as described above. The New Credit Agreement provides for an initial $75 million revolving credit facility, and the commitments thereunder shall expire on the third anniversary of the New Credit Agreement. The borrower shall have the option to seek on up to three occasions an increase in the facility to provide for an additional aggregate amount of availability of up to $50 million. Borrowings by the Company under the New Credit Agreement may be used for general corporate purposes, including working capital and permitted acquisitions. The New Credit Agreement contains certain affirmative and negative covenants.
In addition to its investment portfolio, the Company’s subsidiaries own real property for use as home office facilities for Argonaut Insurance and Great Central, as well as one commercial property in California. These real properties are included in “Other Assets” valued at approximately $0.8 million, which is their original cost less accumulated depreciation.
Concerns over terrorist activity have both curtailed the availability of reinsurance for terrorism related risks and increased the cost of obtaining such reinsurance where it is still available. The effect on the Company’s insurance subsidiaries varies by line of business, but reinsurance coverage for terrorist acts involving nuclear, biological and chemical agents is no longer available or cost prohibitive in some instances, thus preventing ceding of these risks through reinsurance. The Company’s insurance subsidiaries consider the exposure to these risks as well as other risks in order to make appropriate decisions on policy exclusions, pricing and renewals, although laws in many states (and particularly those relating to workers’ compensation insurance) place limits on the ability of insurers to effectively limit these risks by contract.
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 1.1-to-1 as of December 31, 2005. 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.
Index to Financial Statements The Company monitors its consolidated credit risk. The Company reviews credit risk from a variety of sources: credit risk from financial institutions; investment risk; counter-party risk from reinsurers; premium receivables; notes receivable and long-term investment assets; loss sensitive underwriting accounts; and key vendor relationships.
Fayez Sarofim. The Company utilizes Fayez Sarofim & Co. to manage approximately $183.1 million of its investment portfolio, for which an investment advisory fee is paid. Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez Sarofim, a member of the Company’s Board of Directors, is the majority shareholder. Total fees for services paid to Fayez Sarofim & Co. were approximately $0.4 million, $0.4 million and $0.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company believes that this transaction has been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
Index to Financial Statements the Company’s Board of Directors, serves as a consultant to CCML. Prior to December 31, 2004, Mr. Fulkerson also served as a director of the general partner of CCPIII. Mr. Fulkerson retains a 7% ownership interest in the general partner of CCPIII. As such, he has an indirect ownership interest in AAM of less than one-half of one percent.
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, 2005, dividends of $1.9 million were declared, with $0.5 million being accrued and payable as of December 31, 2005 for all the preferred shares outstanding.
Effective January 1, 2006, the Company entered into a second quota share reinsurance program with HCC. Under the terms of the agreement, the Company will assume 2.5% of the business written under HCC’s Energy Program.
The Company’s estimated contractual obligations and commitments as of December 31, 2005 were as follows:
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 losses that occurred in 2005 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.
As of December 31, 2005, the Company recorded gross loss reserves of $1,875.4 million and loss reserves, net of reinsurance, of $1,394.8 million. The Company estimates its range of reserves, net of reinsurance, at $1,271.4 million to $1,575.8 million. Management believes it has recorded its best estimate as of December 31, 2005, based on information currently known to the Company.
Index to Financial Statements Inconsistent judicial decisions and legislative actions continue to broaden liability and scope of policy coverage and to increase the severity of claim payments. As a result, the uncertainties inherent in estimating the ultimate claim costs on the basis of past claims costs have been heightened, further complicating the already complex loss reserving process. Final claim payments, however, may differ from the established reserves, particularly when these payments may not occur for several years. Any adjustments to reserves are reflected in the results for the year during which the adjustments are made.
Realization of deferred tax assets is dependent upon the Company’s generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in the carryback period, generally two years. At the end of 2002, a valuation allowance of $71.9 million was established by the Company against the deferred tax asset. During 2005, 2004 and 2003, the valuation allowance was reduced by $25.1 million, $24.0 million and $22.8 million, respectively, due to consideration of future earnings, and is now fully recovered.
Goodwill. Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. With the restructuring of the Risk Management segment during 2005, the Company reallocated the goodwill previously assigned to this segment in accordance with Statement of Financial Accounting Standard No. 142 “Goodwill and Other Intangibles”. As of December 31, 2005, the Company has $68.3 million of goodwill allocated to the E & S segment, $37.1 million assigned to the Select Markets segment and $0.9 million of goodwill allocated to the Public Entity segment. As required by SFAS No. 142, the Company completed its annual test of goodwill for impairment as of September 30, 2005 and determined that no impairment of goodwill was indicated. Annually, the Company will perform an impairment of goodwill test. If impairment indicators exist between the annual testing periods, management will perform an impairment of goodwill test to determine if the fair value of the reporting unit is below the carrying value and therefore, requires a write-down of goodwill for that reporting unit. In evaluating whether impairment exists in certain reporting units, management also considers the fair value in excess of the carrying value for certain assets.
Share-based Payments. In December 2004, the FASB issued SFAS No. 123-R, ”Share-Based Payments,” which supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options, non-vested stock grants and stock issued under the employee stock plans. The Company adopted FAS 123-R using the modified prospective basis on January 1, 2006. As the Company had various share-based payment plans that were previously subjected to variable accounting under FASB FIN No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” management believes that the adoption of SFAS No. 123-R will not have a material impact on the Company’s results from operations.