The Company leases office space in San Antonio, Texas for its corporate headquarters as well as for certain support functions for Argonaut Insurance Company. Argonaut Insurance Company’s headquarters are located in a facility that consists of an office building on approximately two acres of land in Menlo Park, California. Argonaut Great Central’s headquarters are located in a facility in Peoria, Illinois. Argonaut Insurance Company and Argonaut Great Central own these facilities. Colony leases its home office space in Richmond, Virginia. Rockwood leases its home office space in Rockwood, Pennsylvania. Trident leases its home office space in San Antonio, Texas. 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 Company’s business results also demonstrate a geographic expansion, with a reduction in the concentration of premiums written in California. For the year ended December 31, 2000, approximately 21% of total direct written premiums were concentrated in California. For the year ended December 31, 2003, approximately 16% of direct written premiums were concentrated in California.
Consolidated gross written premiums for the year ended December 31, 2003, included $542.8 million in new business, compared to $332.2 million for the same period of 2002. The increase was primarily attributable to a renewal rights agreement in the excess and surplus lines segment, the public entity segment entering new markets, coupled with the restructuring of the products underwritten by the risk management segment. Consolidated gross written premiums from renewals were $269.7 million for 2003, compared to $287.0 million during 2002. The increases in gross written premiums were partially offset by cancellations and endorsements of $24.1 million for the year ended 2003. The decrease in gross written premiums on renewal business was primarily attributable to the risk management segment exiting certain lines of business, partially offset by rate increases across all lines. The 49% increase in consolidated earned premiums in 2003 over 2002 was primarily attributable to growth in all lines beginning in 2002 and continuing into 2003. Consolidated gross written and earned premiums increased in 2002 primarily due to the inclusion of Colony and Rockwood for the full year period as compared to the four-month period since its acquisition in 2001.
The Company manages its investment portfolio in order to minimize losses, both realized and unrealized. Consolidated gross realized gains were $118.4 million for the year ended December 31, 2003, as compared to $38.9 million and $31.5 million in 2002 and 2001, respectively. Included in consolidated gross realized gains for the year ended December 31, 2003 were gains of approximately $57.6 million from the disposition of four real estate holdings during the first quarter. Additionally, during the third quarter of 2003, the Company reallocated its investment
portfolio, reducing its equity holdings by approximately $86.3 million, resulting in realized gains of approximately $48.8 million. Consolidated gross realized losses were $4.8 million, $12.3 million and $14.4 million for the years ended December 31, 2003, 2002 and 2001, respectively. Included in consolidated gross realized losses for the year ended December 31, 2003 were write downs of approximately $4.0 million from the recognition of other than temporary impairments on certain investment securities.
Consolidated losses and loss adjustment expenses were $395.3 million, $334.6 million and $189.7 million for the years ended December 31, 2003, 2002 and 2001, respectively. The consolidated loss ratios were 70.3%, 88.4% and 85.5% for the years ended December 31, 2003, 2002 and 2001, respectively. Losses and loss adjustment expenses for the year ended 2003 included approximately $10.2 million from the adjustment in the amount ceded to reinsurers for the run-off segment (see discussion on pages 27 - 30) as well as $10.0 million of adverse development in the risk management segment (see discussion on page 23 - 25). During 2002, losses and loss adjustment expenses included reserve strengthening of approximately $59.8 million related to the Company’s run-off segment. Losses and loss adjustment expenses for the year ended 2001 include $7.0 million of reserve strengthening related to the Company’s risk management segment for California workers’ compensation risks. Consolidated reserves for losses and loss adjustment expense were $1,480.8 million, $1,281.6 million and $1,147.8 million as of December 31, 2003, 2002 and 2001, respectively.
Consolidated underwriting, acquisition and insurance expenses were $191.0 million, $144.4 million and $99.6 million for the years ended December 31, 2003, 2002 and 2001, respectively. The consolidated expense ratios were 33.9%, 38.2% and 44.9% for the years ended December 31, 2003, 2002 and 2001. The declines in the expense ratios primarily resulted from economies of scale realized from increased gross written premiums, primarily in the excess and surplus segment and the public entity segment.
Interest expense was $8.4 million for the year ended December 31, 2003. Interest expense of approximately $6.6 million was recorded for funds withheld by the Company under a retroactive reinsurance contract. Interest expense of approximately $0.6 million was recorded as a result of the junior subordinated debentures issued by the Company during 2003. Interest expense of approximately $1.3 million was recorded for various other funds withheld by the insurance subsidiaries.
The consolidated provision for income taxes as of December 31, 2003 was $26.3 million, including a reduction of the deferred tax asset valuation allowance of $22.8 million. The consolidated provision for income taxes for the year ended December 31, 2002 was $65.9 million, including the establishment of a valuation allowance on deferred tax of $71.9 million. The reduction of the deferred tax valuation allowance in 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”. Management anticipates the valuation allowance will ultimately be recovered in the future. The Company evaluates the adequacy of the valuation allowance on a regular basis.
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 on a consolidated basis. Although this measure of profit (loss) does not replace net income (loss) computed in accordance with accounting principles generally accepted in the United States as a measure of profitability, management utilizes this measure of profit (loss) to focus its segments on generating operating income which excludes realized gains and losses on sales of investments.
The following table summarizes the results of operations for the excess and surplus segment:
Gross written and earned premiums for the year ended 2003 increased primarily as the result of rate increases and new business. For the year, gross written premiums derived from new business increased $81.7 million to $268.0 million, primarily due to business written through the Fulcrum Insurance Company renewal rights acquisition. Renewal gross written premiums increased $57.7 million to $140.7 million for the year ended December 31, 2003. A larger base of expiring premiums compounded by rate increases was the primary driver for the increase in renewal premiums. This trend is a reflection of the current environment of the excess and surplus lines market, in that the current year premium has a similar risk profile to expiring policies, and is being written at higher rates. Partially offsetting these increases were cancellations and endorsements which reduced gross written premiums by approximately $24.1 million for the year. Results for the year ended December 31, 2001 include activity for the four months from the acquisition of Colony.
On March 31, 2003, Colony entered into a quota share reinsurance agreement with HCC Insurance Holdings, Inc. (“HCC”). Under the terms of this agreement, the Company cedes 15% of the gross written premiums from the excess and surplus lines segment to HCC and HCC will, in turn, assume 15% of the losses. As of December 31, 2003, the Company ceded $41.3 million of gross written premiums, $17.1 million of earned premiums and $14.3 million in losses and loss adjustment expense. The Company receives a ceding commission to offset its acquisition costs related to these premiums. As of December 31, 2003, the Company earned a ceding commission of $3.0 million.
Increases in net investment income were the result of an increase in invested assets resulting from positive cash flows over the past year combined with a second quarter $12.0 million capital contribution. Net invested assets increased to $473.0 million as of December 31, 2003 compared to $309.3 million as of December 31, 2002.
Risk Management. Workers’ compensation is the primary line underwritten by Argonaut Insurance Company, concentrating on casualty risk management solutions for accounts that generally produce annual premiums between $500,000 and $5.0 million. The insurance products are designed to meet the needs of business customers that are willing and able to bear a substantial portion of the insurance risk through deductibles and retrospectively rated premiums. These customers typically select Argonaut Insurance Company as a risk management provider based on the quality of its loss control and claims handling expertise.
For the year ended 2003, gross written premiums totaled $197.4 million compared to $201.9 million in 2002. During the first quarter of 2003, this segment was restructured by reducing the number of product offerings and distribution channels. Argonaut Insurance Company significantly reduced workers’ compensation policies written on a guaranteed cost basis, wrap up policies (or large construction policies) and smaller policies (premium of less than $25,000). This restructuring resulted in the decrease in Argonaut Insurance Company’s gross written premiums for the year ended December 31, 2003. Gross written premiums from new business totaled $131.1 million in 2003, $82.9 million in 2002 and $45.3 million in 2001. Gross written premiums from renewal business were $66.3 million in 2003, $94.8 million in 2002 and $86.5 million in 2001.
During 2003, Argonaut Insurance Company entered into an agreement with Kemper Insurance Company (“Kemper”) to purchase the renewal rights for certain national accounts. Under the terms of the agreement, Argonaut Insurance Company had the right to acquire the assets and liabilities of certain policies originally underwritten by Kemper. Included in the $197.4 million of risk management premiums referenced above is $22.7 million of new business generated under this agreement.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share reinsurance program to assume directors and officers liability policies underwritten by HCC Insurance Holdings, Inc. (HCC). Under the terms of the agreements, Argonaut Insurance Company assumed 3.33% of the losses under HCC’s USA Directors and Officers Liability program and 5% of the losses under HCC’s International Directors and Officers Liability program. Gross written premiums assumed under these programs totaled $12.6 million for the year ended December 31, 2003, and is included in the $197.4 million of gross written premiums for the risk management segment.
The decline in earned premiums to $109.2 million in 2002 versus $126.5 million in 2001 was primarily the result of an increase in ceded premiums. During 2002, the Company decreased its loss retention to $250,000 per occurrence from $1 million. The effect of this treaty coupled with higher reinsurance rates incurred for 2002 increased the amount of premiums ceded to reinsurers. The increase in the reinsurance costs incurred in 2002 was primarily related to the terrorist attacks in September 2001.
The improvement in the loss ratio over the three-year period is the result of the Company re-underwriting this book of business beginning in the third quarter of 2000 and continuing into 2003. For the last six months of 2003 the loss ratio for the risk management segment was 72.3%. Management anticipates continued improvement in the results of this segment; however, there can be no assurance that future results will be consistent with this current trend.
The expense ratio for the year ended 2003 was 49.9% versus 47.7% in 2002 and 42.9% in 2001. The increase in the expense ratio in 2003 versus 2002 was primarily attributable to (a) $1.9 million of expense for the settlement of a lawsuit; (b) restructuring charges of $1.3 million; and, (c) the Company deferred $13.0 million of acquisition costs in 2002. During 2001, the Company did not defer acquisition costs.
In the first quarter of 2003, the Company restructured the operations of Argonaut Insurance Company. With the elimination of non-strategic products, Argonaut Insurance Company has reduced its workforce by 67 employees as of December 31, 2003. Severance costs of $0.9 million and outplacement and relocation costs of $0.1 million had been recognized as of December 31, 2003. Additionally, the Company closed three offices at a total cost of $0.3 million. The costs associated with the restructuring are included in the underwriting expense line item of this segment.
Net investment income declined to $27.3 million for the year ended December 31, 2003 as compared to $31.4 million in 2002 due to lower yields. Partially offsetting this decrease were higher invested balances due primarily to capital contributions. Invested assets as of December 31, 2003 were $729.9 million compared to $629.0 million as of December 31, 2002. The decrease in net investment income for the year ended December 31, 2002 as compared to 2001 was primarily due to the reduction in invested assets, which were $690.5 million as of December 31, 2001.
Specialty Commercial. Argonaut Great Central and Rockwood provide specialty commercial insurance coverage. Argonaut Great Central specializes in commercial multi-peril, workers’ compensation and umbrella insurance coverage in three broadly defined markets: food and hospitality, retail services and organizations and institutions. Rockwood provides commercial property and casualty insurance primarily in Pennsylvania and Maryland. Rockwood focuses on underwriting workers’ compensation coverage, general liability and other property and casualty coverage for commercial and mining risks. Rockwood was acquired by the Company effective September 1, 2001, and its results of operations are included from this date.
Losses and loss adjustment expenses for the year ended December 31, 2003 resulted in a loss ratio of 70.8% compared to 70.9% and 73.8% for 2002 and 2001, respectively. Prior accident year development in workers’ compensation due to higher than anticipated indemnity and medical exposures was partially offset by favorable development in the other lines of business. Catastrophe losses of $3.9 million in 2003 were comparable to 2002 losses of $3.8 million. The specialty commercial segment’s loss reserves were $182.0 million, $172.2 million and $156.9 million as of December 31, 2003, 2002 and 2001, respectively.
Net investment income declined $0.6 million for the year ended December 31, 2003 to $9.6 million as compared to 2002 due to lower yields. Partially offsetting this decrease were higher invested balances from cash flows from operations. Invested assets as of December 31, 2003 were $246.3 million compared to $230.0 million as of December 31, 2002. The increase in net investment income for the year ended December 31, 2002 as compared to 2001 was primarily attributable to Rockwood contributing investment income for the complete twelve-month period, as opposed to the four months since acquisition in 2001.
Public Entity. Trident functions as a managing general underwriter, and provides insurance solutions for small to medium sized governmental entities throughout the United States. Trident offers comprehensive insurance packages, including property, inland marine, crime, general liability, public officials’ liability, law enforcement liability, automobile liability, automobile physical damage and excess liability coverages. Trident currently underwrites a majority of its products through Argonaut Great Central and Argonaut Insurance Company.
Losses and loss adjustment expenses for the year ended December 31, 2003 resulted in a loss ratio of 63.3% compared to 70.4% in 2002 and 73.2% for 2001. The decrease in the loss ratio is attributable to the maturation of the book of business as well as a decrease in the percentage of business reinsured through quota share arrangements. Loss reserves for the public entity segment were $28.8 million, $11.5 million and $4.0 million as of December 31, 2003, 2002 and 2001, respectively.
For the year ended December 31, 2003, the run-off segment recorded a segment loss of $12.7 million, compared to $67.8 million for the same period of 2002. The underwriting loss for this segment was zero for the year ended December 2001.
Argonaut Insurance Company is exposed to asbestos liability at the primary level through claims filed against its direct insureds, as well as through its position as a reinsurer of other primary carriers. Argonaut Insurance Company’s direct liability arises primarily from policies issued from the mid 1970s to early 1980s which pre-dated policy contract wording that excluded asbestos exposure. The majority of the policies were issued on behalf of small contractors or construction companies. The Company believes that the frequency and severity of asbestos claims for such insureds is typically less than that experienced for large, industrial manufacturing and distribution concerns.
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, 2003.
In the third quarter of 2003, the Company completed an analysis of the recoverability of losses and loss adjustment expense reserves related to 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, and related policies and reinsurance contracts, and, 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, 2003 were $219.3 million, net of reinsurance but before effects of the adverse development cover, including reserves for environmental and asbestos claims of $180.0 million. Management uses various actuarial methods to determine the potential range of losses for the run-off lines in total, which resulted in a range of potential ultimate liability, net of reinsurance, of $152.2 million to $335.5 million. In determining its best estimate, management primarily relied on the report year method. The report year method relies most heavily on the Company’s historical claims and severity information, whereas other methods rely more heavily on industry information. This method produces an estimate of losses which have been incurred but not yet reported based on projections of numbers of future claims and the average severity for those future claims. The severities were calculated based on Argonaut specific data and in management’s opinion best reflect Argonaut liabilities based upon the insurance policies issued. As a result of this reserve analysis, the reserve for incurred but not reported environmental and asbestos claims (net of reinsurance) at December 31, 2003, was $99.6 million compared to $102.1 million and $58.2 million as of December 31, 2002 and 2001, respectively. The reserve for incurred but not reported claims for the remaining run-off lines (net of reinsurance) was $11.8 million as of December 31, 2003, compared to $15.3 million and $18.8 million as of December 31, 2002 and 2001, respectively.
The above tables indicate downward trends in the number of open claims at the end of each year and total gross payments over the past three years. Because of the types of coverages within Argonaut Insurance Company’s run-off lines of business, a significant amount of judgment and uncertainty exists in establishing the reserves for losses and loss adjustment expenses. Factors that increase these uncertainties are: (1) lack of historical data, (2) inapplicability of standard actuarial projection techniques, (3) uncertainties regarding ultimate claim costs, (4) coverage interpretations, and (5) the judicial, statutory and regulatory environments under which these claims may ultimately be resolved. Significant uncertainty remains as to the ultimate liability to the Company due to the potentially long waiting period between exposure and emergence of any bodily injury or property damage and the resulting potential for involvement of multiple policy periods for individual claims. Additionally, recent industry trends show an increasing number of claims being filed by individuals who claim asbestos exposure, but who have no symptoms of asbestos-related disease. Due to these uncertainties, the current trends may not be indicative of future results.
For the year ended December 31, 2003, net cash provided by operating activities was $184.7 million, compared to $116.8 million for the year ended December 31, 2002 and net cash used of $37.4 million for the year ended December 31, 2001. The cash flow provided by operating activities in 2003 and 2002 was primarily the result of improved underwriting results and increased premium volume. The cash flow used by operations in 2001 was primarily the result of claim payments on the run-off lines.
Net cash used by investing activities totaled $336.1 million and $40.7 million for the year ended December 31, 2003 and 2002, respectively. Cash was primarily used to acquire fixed maturity investments, offset by cash received from sales, calls and maturities of fixed asset securities and sales of equity securities. As of December 31, 2003, a portion of the investment portfolio was invested in short-term, liquid investments. For the year ended December 31, 2001, cash generated by investing activities totaled $103.5 million, primarily due to the sales and calls of investments to finance the acquisition of Front Royal, Inc.
In the fourth quarter of 2003, the Company sold 5,368,000 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 $15.80 per share, less an underwriting discount of 5.5%. The net proceeds from the sale of the common stock were approximately $79.8 million, after deducting the underwriting discounts and commissions and offering expenses.
In March 2003, the Company borrowed $18.0 million from HCC under a note payable. The note was due March 31, 2006 and bore interest at 12% annually. In April 2003, the Company repaid $6.0 million plus accrued interest upon the closing of the sale of 500,000 preferred shares. In conjunction with the closing of the common stock offering in the fourth quarter of 2003, the Company issued 596,474 shares of the Company’s common stock to HCC in a private placement. The shares were issued at a price of $14.931 per share, which was equal to the public offering price in the underwritten public offering less the underwriting discount. The Company used the proceeds from this private placement to repay approximately $8.9 million of the $12.0 million aggregate remaining principal amount of the note payable, plus accrued interest on that portion of the note. In December 2003, the Company repaid the balance of the note in full.
On December 16, 2003, Argonaut Group Statutory Trust III, a Delaware statutory trust and wholly-owned subsidiary of the Company, sold 12,000 Floating Rate Capital Securities (the “Capital Securities”) (liquidation amount $1,000 per Capital Security) to InCapS Funding II, Ltd. in a private sale for $12.0 million. The Trust used the proceeds from this sale to buy a series of Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Debentures”) due 2034 from the Company. The Debentures have the same payment terms as the Capital Securities.
The interest rate on the Debentures and the Capital Securities is equal to 3-Month LIBOR plus 4.10%, reset quarterly, not to exceed 12.5%. The Debentures are unsecured and are subordinated in right of payment to all of the Company’s future senior indebtedness. Beginning in January 2009, the Company will have the right to redeem the Debentures, in whole or in part, at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption. The Company will also have the right to redeem all of the Debentures between January 2004 and 2008 upon the happening of specified events at a price ranging from 104.75% to 100.95% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption. The majority of these proceeds were contributed to the insurance subsidiaries of the Company.
The Company’s insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to cover operating expenses. During the two years ended December 31, 2003, the Company’s liquidity generated from operations and investment income were sufficient to meet obligations. During the year ended December 31, 2001, the Company had to utilize cash from the sale of securities to supplement operating commitments. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as satisfy its commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
The Company maintains a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard its financial position. Across all sectors, reinsurance rates have substantially increased. The additional reinsurance costs of the Company’s program, to the extent not passed on to customers through increased rates may have a negative impact on liquidity.
The agreement provides up to $119.0 million of future adverse development, if any, on workers’ compensation, commercial multiple peril, general liability and asbestos, environmental and other latent losses. The Company has $71.4 million of unused coverage under the retroactive adverse loss development reinsurance agreement for future adverse development. The cessions for adverse development are calculated on a tiered structure and subject to certain limitations. The Company has the option to commute the reinsurance agreement at any time if the funds withheld balance is positive.
The insurance subsidiaries must maintain certain levels of policyholders’ surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners suggest that a property and casualty insurer’s ratio of annual statutory net premium written to policyholders’ surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the insurance subsidiaries to their combined policyholders’ surplus was 1.3-to-1 as of December 31, 2003. Current levels of policyholders’ surplus are adequate to support current premium writings, based on this standard. The Company monitors premium and statutory surplus levels of the insurance subsidiaries to ensure that the subsidiaries maintain adequate premiums to surplus ratios. Failure of any insurance subsidiary to maintain adequate levels of policyholders’ surplus could negatively impact the ability to write additional premiums.
In addition, regulators and rating agencies utilize an RBC test designed to measure the acceptable amount of surplus an insurer should maintain, based on specific inherent risks of each insurer. Insurers failing to meet this benchmark level may be subject to scrutiny by the insurer’s domiciliary insurance department and potentially result in rehabilitation or liquidation. As of December 31, 2002, Argonaut Insurance Company’s RBC ratio was within the Company Action Level Event. At this level, the regulated insurer is required to submit a Comprehensive Plan of Action to the regulatory body detailing the steps it is taking to raise the RBC ratio above the minimum specified by statute.
The pension plan measurement date for purposes of the consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which management believes the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2003, the Company used the following assumptions: a discount rate of 6.25% and an expected rate of return on plan assets of 6.0%.
Effective November 2003, the Company curtailed the pension plan. This curtailment resulted in a reduction of pension expense of $3.9 million. Total pension expense for the year ended December 31, 2003, prior to the effects of the curtailment, was approximately $1.1 million. As of December 31, 2003, the Company has a prepaid pension asset of approximately $7.3 million. The estimated pension liability as of December 31, 2003 was $25.2 million (vested and non-vested participants.) Based on the current funding status of the pension plan, the effects of the curtailment, the expected changes in pension plan asset values and pension obligations in 2004, the Company does not believe any significant funding of the pension plan will be required during the year ended December 31, 2004.
On March 31, 2003, the Company borrowed $18.0 million from HCC. The note payable was due March 31, 2006, bore interest at 12% annually and was prepayable at the Company’s option at anytime. The note contained certain covenants, one of which required repayment should the Company enter into other debt agreements or issue additional shares of Series A Mandatory Convertible Preferred Stock. On April 16, 2003, the Company repaid $6.0 million principal amount of the note, plus accrued interest in conjunction with the issuance and proceeds of additional preferred shares. On May 7, 2003, the Company received a waiver from HCC of the requirement to use proceeds from the Company’s issuance of its Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 to repay the note payable. In November 2003, HCC converted approximately $8.9 million of the outstanding note balance into the Company’s common shares. In December 2003, the Company paid off the outstanding principal and interest in full.
On March 31, 2003, Colony Insurance Company entered into a quota share reinsurance program with HCC. As of December 31, 2003, the Company ceded approximately $41.3 million of gross written premiums, $17.1 million of earned premiums and $14.3 million of losses and loss adjustment expenses. The Company receives a ceding commission to offset its acquisition costs related to these premiums. As of December 31, 2003, the Company had earned a ceding commission of $3.0 million.
The Company’s estimated contractual obligations and commitments as of December 31, 2003 are as follows:
(1) Interest only due on Junior Subordinated Debentures through 2008. Principal due beginning May 2008.
(3) 7% dividend on convertible preferred stock. Obligation calculated assuming preferred stock will convert on 10 year anniversary date.
The discussion of the adoption and pending adoption of recently issued accounting policies is included in note 1 - “Business and Significant Accounting Policies” in the Notes to the Consolidated Financial Statements, included in Item 8 “Financial Statements and Supplementary Data” on page 40.
Reserves for Losses and Loss Adjustment Expenses. The Company establishes reserves for the estimated total unpaid costs of losses and loss adjustment expense (“LAE”), which cover events that occurred in 2003 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, 2003, the Company recorded gross loss reserves of $1,480.8 million and loss reserves, net of reinsurance, of $1,135.4 million, prior to the effect of the adverse development cover. The Company estimates its range of losses, net of reinsurance, at $1,003.8 million to $1,417.1 million. Management believes it has recorded its best estimate as of December 31, 2003, based on current information know to the Company.
The Company utilizes a variety of actuarial techniques and methods to determine the ultimate losses and loss adjustment expenses. Methods used include the paid loss development method, incurred loss development method, Bornhuetter-Ferguson method, loss ratio method, report year method and claim count development method. The combination of the methods produces a point estimate for each line of business, which the Company records as management’s best estimate given the available facts at that point in time. Each business segment is analyzed individually. The Company primarily uses internal data in the analysis, however, industry data is used where credibility of internal data is low and in the development of tail factors. The Company analyzes loss reserves on a monthly basis. An independent actuary reviews the risk management reserves on a quarterly basis. A study of reserves by the Company’s consulting actuary for the run-off lines is conducted annually using additional actuarial methods.
In addition to the previously described general uncertainties encountered in estimating reserves, there are significant additional uncertainties in estimating the amount of the Company’s potential losses from asbestos and environmental claims. Reserves for asbestos and environmental claims cannot be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding these types of claims. Among the uncertainties impacting the estimation of such losses are: (1) potentially long waiting periods between exposure and emergence of any bodily injury or property damage; (2) difficulty in identifying sources of environmental or asbestos contamination; (3) difficulty in properly allocating responsibility and/or liability for environmental or asbestos damage; (4) changes in underlying laws and judicial interpretation of those laws; (5) potential for an environmental or asbestos claim to involve many insurance providers over many policy periods; (6) long reporting delays from insureds to insurance companies; (7) historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of claims; (8) questions concerning interpretation and application of insurance coverage; and (9) uncertainty regarding the number and
identity of insureds with potential asbestos or environmental exposure. Case reserves and expense reserves for costs of related litigation have been established where sufficient information has been developed. Additionally, incurred but not reported reserves have been established to cover additional exposure on known and unknown claims.
Management believes that the aggregate loss reserves at December 31, 2003 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. In establishing these reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts and the legislatures in the recent past and the possibility of similar interpretations in the future, particularly with regard to asbestos and environmental claims, additional loss reserves may develop in future periods. These potential increases cannot be reasonably estimated at the present time. Any increases could have an adverse impact on future operating results, liquidity, risk-based capital ratios and the ratings assigned to the insurance subsidiaries by the nationally recognized insurance rating agencies.
Deferred Tax Assets and Liabilities. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are recognized for temporary differences that will result in taxable amounts in future years. Deferred tax assets are recognized for deductible temporary differences and tax operating loss and tax credit carryforwards. The deferred tax assets and liabilities are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The components of the Company’s deferred tax asset are net operating loss carryforwards and temporary differences primarily attributable to loss reserve discounting. The net operating loss carryforwards begin expiring after 2009. The Company’s deferred tax liabilities resulted from unrealized gains in the investment portfolio.
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 2003, the valuation allowance was reduced by $22.8 million due management’s consideration of limited amounts of future income in accordance with SFAS No. 109. The Company expects that it will ultimately recognize the deferred tax asset in the future and regularly evaluates the deferred tax asset valuation allowance. If future taxable income is not sufficient to recover the deferred tax asset, net of the valuation allowance, as of
The report of the independent auditors, the consolidated financial statements of Argonaut Group, Inc. and subsidiaries and the supplementary financial statements called for by this Item 8 are included in this report beginning on page and are incorporated herein by reference.