During the 2007 fourth quarter, Alleghany identified an error representing the over-accrual of current taxes payable for periods prior to January 1, 2003. In order to correct this historical error, Alleghany recorded the following immaterial corrections to prior period financial statement amounts: (a) a cumulative increase of approximately $26.1 million to opening retained earnings in the consolidated statement of shareholders’ equity for the year ended December 31, 2003; and (b) a comparable decrease in current taxes payable in the consolidated statement of condition at December 31, 2006, 2005, 2004 and 2003. In addition, per share amounts have been adjusted for subsequent common stock dividends.
“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk” contain disclosures which are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts, and can be identified by the use
of words such as “may,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan,” “believe,” “potential,” “should,” “continue” or the negative versions of those words or other comparable words. These forward-looking statements are based upon our current plans or expectations and are subject to a number of uncertainties and risks that could significantly affect current plans, anticipated actions and our future financial condition and results. These statements are not guarantees of future performance, and we have no specific intention to update these statements. The uncertainties and risks include, but are not limited to, risks relating to our insurance operating units such as
Additional risks and uncertainties include general economic and political conditions, including the effects of a prolonged U.S. or global economic downturn or recession; changes in costs; variations in political, economic or other factors; risks relating to conducting operations in a competitive environment; effects of acquisition and disposition activities, inflation rates or recessionary or expansive trends; changes in interest rates; changes in market prices of our significant equity investments; extended labor disruptions, civil unrest or other external factors over which we have no control; and changes in our plans, strategies, objectives, expectations or intentions, which may happen at any time at our discretion. As a consequence, current plans, anticipated actions and future financial condition and results may differ from those expressed in any forward-looking statements made by us or on our behalf.
As noted above, as of any balance sheet date, not all claims that have occurred have been reported to our insurance operating units, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled by the insurer is referred to as the “claim tail.” Property claims usually have a fairly short claim tail and, absent claim litigation, are reported and settled within no more than a few years of the date they are reported. For short-tail lines, loss reserves consist primarily of reserves for reported claims. The process of recording quarterly and annual liabilities for unpaid losses and loss adjustment expenses for short-tail lines is primarily focused on maintaining an appropriate reserve level for reported claims and IBNR, rather than determining an expected loss ratio for the current business only, and use of other actuarial methods discussed below for long-tail business such as casualty. Specifically, we assess the reserve adequacy of IBNR in light of such things as the current levels of reserves for reported claims and expectations with respect to reporting lags, historical data, legal developments, and economic conditions, including the effects of inflation. At December 31, 2007, the amount of IBNR for short-tail claims represented only approximately 1 percent, or $28.1 million of Alleghany’s total gross loss and loss adjustment expense liabilities of $2,580.1 million, and approximately 1 percent, or $20.1 million of Alleghany’s total net loss and loss adjustment expense liabilities of $1,664.7 million.
Our loss reserve review processes use actuarial methods that vary by insurance operating unit and line of business and produce point estimates for each class of business. The actuarial methods used by our insurance operating units include the following methods:
Reported and paid loss emergence patterns: represent management’s expectation of how losses will be reported and ultimately paid in the future based on the historical emergence patterns of reported and paid losses, and are derived from past experience of our insurance operating units, modified for current trends and industry data. These emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value.
Prior Year Development. Our insurance operating units continually evaluate the potential for changes, both positive and negative, in their estimates of loss and loss adjustment expense liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid losses and loss adjustment expenses established in prior years, these liabilities are periodically analyzed and their expected ultimate cost adjusted, where necessary, to reflect positive or negative development in loss experience and new information, including, for certain catastrophic events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid losses and loss adjustment expenses, both positive and negative, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior year reserve development. Each of RSUI, CATA, and Darwin adjusted its prior year loss and loss adjustment expense reserve estimate during 2007 based on current information that differed from previous assumptions made at the time such loss and loss adjustment expense reserves were previously estimated.
During 2006, RSUI made a net reserve adjustment of $8.9 million. This net reserve adjustment primarily reflected a decrease in estimated reinsurance recoverables related to Hurricane Katrina due to a change in the composition of estimated ceded losses, partially offset by prior year reserve releases related to Hurricane Wilma and 2004 third quarter hurricanes. The reserving actions related to Hurricane Katrina reflected a review completed by RSUI during the 2006 fourth quarter of Hurricane Katrina reinsurance cessions that showed RSUI’s net retained losses would be slightly higher than previously estimated. With respect to the 2004 third quarter hurricanes, the reserve releases reflected a determination that paid losses for such hurricanes were at or close to ultimate expected losses.
During 2007, Darwin had a net release of $13.8 million of prior year reserves, and corresponding adjustments in ceded reinsurance premiums totaling $7.4 million. The reduction reflects favorable loss emergence compared with loss emergence patterns assumed in earlier periods for such lines of business due to continued favorable loss development. The reduction also reflects a change in reserving methodology to give greater weight to historical claims experience. Such reduction did not impact the assumptions used in estimating Darwin’s loss and loss adjustment expense liabilities for business earned in 2007. During 2006, Darwin made $4.0 million of prior year loss and loss adjustment expense reserve adjustments, consisting of $2.3 million of prior year loss reserve releases reflecting favorable loss emergence in the 2003 and 2004
accident years compared with loss emergence patterns assumed in earlier periods for such accident years, and a corresponding $1.7 million reduction in ceded premiums.
Until 2006, Darwin used industry data to estimate reserves as it lacked meaningful claims history due to its commencement of operations in March 2003. Beginning in 2006 and continuing into 2007, as industry data was gradually replaced with Darwin’s own claims experience, Darwin began to recognize favorable claims emergence on prior accident years.
There were no significant assumptions made at December 31, 2007 in estimating Alleghany’s loss and loss adjustment expense liabilities that were inconsistent with historical loss development patterns.
For both asbestos and environmental impairment reinsurance claims, CATA establishes case reserves by receiving case reserve amounts from its ceding companies and verifies these amounts against reinsurance contract terms, analyzing from the first dollar of loss incurred by the primary insurer. In establishing the liability for asbestos and environmental impairment claims, CATA considers facts currently known and the current state of the law and coverage litigation. Additionally, ceding companies often report potential losses on a precautionary basis to protect their rights under the reinsurance arrangement, which generally calls for prompt notice to the reinsurer. Ceding companies, at the time they report potential losses, advise CATA of the ceding companies’ current estimate of the extent of the loss. CATA’s claims department reviews each of the precautionary claims notices and, based upon current information, assesses the likelihood of loss to CATA. This assessment is one of the factors used in determining the adequacy of the recorded asbestos and environmental impairment reserves. Although we are unable at this time to determine whether additional reserves, which could have a material impact upon our results of operations, may be necessary in the future, we believe that CATA’s asbestos and environmental impairment reserves are adequate as of December 31, 2007.
We hold our equity and debt securities as available for sale, and as such, these securities are recorded at fair value. We continually monitor the difference between cost and the estimated fair value of our investments, which involves uncertainty as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in common stockholders’ equity. If we believe the decline is other than temporary, we write it down to the carrying value of the investment and record a realized loss on our statement of earnings. Management’s assessment of a decline in value includes, among other things,
A debt security is impaired if it is probable that we will not be able to collect all amounts due under the security’s contractual terms. An equity investment is impaired when it becomes apparent that we will not recover its cost over the expected holding period. Further, for securities expected to be sold, an other-than-temporary impairment charge is recognized if we do not expect the fair value of a security to recover its cost prior to the expected date of sale. If that judgment changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary. Risks and uncertainties are inherent in the methodology we use to assess other-than-temporary declines in value. Risks and uncertainties could include, but are not limited to, incorrect or overly optimistic assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral and unfavorable changes in economic or social conditions, interest rates or credit ratings.
The profitability of our insurance operating units, and as a result, our profitability, is primarily impacted by the adequacy of premium rates, as well as the cost of reinsurance, level of catastrophe losses, intensity of competition and investment returns. The ultimate adequacy of premium rates is not known with certainty at the time a property casualty insurance policy is issued because premiums are determined before claims are reported. The adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural disasters, regulatory measures and court decisions that define and expand the extent of coverage and the effects of economic inflation on the amount of compensation due for injuries or losses.
The profitability of our insurance operating units is impacted by price competition. Historically, the financial performance of the property and casualty insurance industry has tended to fluctuate in cyclical periods of price competition and excess underwriting capacity, known as a soft market, followed by periods of high premium rates and shortages of underwriting capacity. Although an individual insurance company’s
financial performance is dependent on its own specific business characteristics, the profitability of most property and casualty insurance companies tends to follow this cyclical market pattern. As discussed in more detail below, our insurance operating units experienced increased pricing competition in certain of their lines of business during 2006, and this competitive environment continued and increased during 2007, resulting in a decrease in pricing over that time. The impact of this price competition cannot be fully quantified in advance, but it is possible that this price competition, to the extent the loss costs of our insurance operating units exceed premiums, could have a material adverse effect on the results of our insurance operating units in the future.
Finally, profitability is also affected by our investment income. Our invested assets, which are derived primarily from our own capital and cash flow from our insurance operating units, are invested principally in fixed income securities, although we also invest in equity securities. The return on fixed income securities is primarily impacted by general interest rates and the credit quality and duration of the securities.
Net earnings from continuing operations for 2007 and 2006 include the $5.2 million tax adjustment and $10.8 million tax benefit noted above. Net earnings from continuing operations for 2005 reflect a reduction in taxes as a result of the significant catastrophe losses incurred during the 2005 third quarter.
Includes the results of EDC, net of purchase accounting adjustments, commencing July 18, 2007. See Note 9 to the Notes to our consolidated financial statements set forth in Item 8 of this Form 10-K Report.
Underwriting expenses represent commission and brokerage expenses and that portion of salaries, administration and other operating expenses directly attributable to underwriting activities, whereas the remainder constitutes other expenses.
The decrease in gross premiums written in 2007 from 2006 primarily reflects continuing and increasing pricing competition in RSUI’s general liability, umbrella and property lines of business. RSUI’s net premiums earned in both property and casualty lines of business increased in 2007 from 2006. The increase in property net premiums earned is due primarily to increased retentions and reduced reinsurance limits being purchased at lower rates for catastrophe and per risk coverage renewed at May 1, 2007. The increase in casualty net premiums earned primarily reflects the growth of RSUI’s binding authority line of business which writes small, specialized coverages pursuant to underwriting authority arrangements with managing general agents. The increase in net premiums earned in 2006 from 2005 primarily reflects volume increases in all casualty lines of business, due primarily to growth in gross premiums written. In addition, net premiums earned increased in property lines of business reflecting higher prices on catastrophe-exposed risks and increased retentions from reduced cessions under RSUI’s property surplus share reinsurance treaties, partially offset by higher per risk and catastrophe reinsurance costs and a decrease in exposed limits.
RSUI’s underwriting profit for 2007 increased from 2006, primarily reflecting an increase in net premiums earned and lower than expected current accident year property losses, partially offset by higher underwriting expenses and the net reserve increase of $8.5 million, as discussed above. RSUI’s underwriting profit for 2006 increased from 2005, reflecting significantly lower net catastrophe losses, as noted above, partially offset by an $8.9 million net reserve adjustment. This net reserve adjustment primarily reflected a decrease in estimated reinsurance recoverables related to Hurricane Katrina due to a change in the composition of estimated ceded losses, partially offset by prior year reserve releases related to Hurricane Wilma and 2004 third quarter hurricanes. The reserving actions related to Hurricane Katrina reflect a review completed by RSUI during the 2006 fourth quarter of Hurricane Katrina reinsurance cessions that showed RSUI’s net retained losses would be slightly higher than previously estimated. With respect to the 2004 third quarter hurricanes, the reserve releases reflected a determination that paid losses for such hurricanes were at or close to ultimate expected losses.
Additional information regarding RSUI’s use of reinsurance and risks related to reinsurance recoverables can be found on pages 18 through 20 and pages 26 and 27 of this Form 10-K Report. Additional information regarding RSUI’s adjustments to and releases of prior year reserves can be found on page 35 and pages 45 and 46 of this Form 10-K Report.
AIHL Re was formed in June 2006 as a captive reinsurance subsidiary of AIHL to provide catastrophe reinsurance coverage for RSUI. AIHL Re and RSUI entered into a reinsurance agreement, effective July 1, 2006, whereby AIHL Re, in exchange for market-based premiums, took that portion of RSUI’s catastrophe reinsurance program not covered by third-party reinsurers. The cumulative premiums ceded from RSUI to AIHL Re under this agreement for the coverage period was $59.1 million, which reflects a $1.1 million premium adjustment recorded during the second quarter of 2007. This reinsurance coverage expired on April 30, 2007 and AIHL Re is not participating in RSUI’s catastrophe reinsurance program for the 2007-2008 period.
The increases in Darwin’s net premiums earned in 2007 from 2006, and in 2006 from 2005, reflect increases in gross premiums written reflecting growth in Darwin’s E&O and medical malpractice lines of business, improved pricing and terms under Darwin’s reinsurance programs compared with its expired programs, and a reduction of ceded premiums, resulting from the release of prior accident year loss reserves. The increases in loss and loss adjustment expenses and underwriting expenses in 2007 from 2006, and in 2006 from 2005, primarily reflect an increase in premium volume, partially offset by a reduction of reserves for prior accident years. The increases in underwriting profit in 2007 from 2006, and in 2006 from 2005, primarily reflect an increase in net premiums earned and releases of prior year loss reserves and corresponding adjustments in ceded reinsurance premiums. The releases of prior year loss reserves and corresponding
adjustments in ceded reinsurance premiums totaled $21.2 million in 2007 and $4.0 million in 2006, compared with no prior year loss reserve releases in 2005.
AIHL’s insurance operating units periodically analyze and adjust their expected ultimate cost, where necessary, to reflect positive or negative development in loss experience and new information, including, for certain catastrophic events, revised industry estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid losses and loss adjustment expenses, both positive and negative, are reflected in our financial results in the periods in which these adjustments are made and are referred to as prior year reserve development. The following table presents the reserves established in connection with the losses and loss adjustment expenses of AIHL’s insurance operating units on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate losses, including IBNR, and loss adjustment expenses.
Primarily consists of excess and umbrella, D&O liability, professional liability, general liability and medical malpractice liability.
Primarily consists of loss and loss adjustment expense reserves for discontinued lines of business and loss reserves acquired in connection with prior acquisitions for which the sellers provided loss reserve
Gross Reserves. The decrease in gross loss and loss adjustment expense reserves at December 31, 2006 from December 31, 2005 primarily reflects a reduction in RSUI’s property loss and loss adjustment expense reserves, partially offset by increases in casualty loss and loss adjustment expense reserves at RSUI and Darwin. The decrease in gross property loss and loss adjustment expense reserves is mainly due to gross loss payments on 2004 and 2005 hurricane related losses, principally Hurricane Katrina. The increase in casualty gross loss and loss adjustment expense reserves primarily reflects anticipated loss reserves on current accident year gross premiums earned and limited gross paid loss activity for the current and prior casualty accident years.
Net Reserves. The increase in net loss and loss adjustment expense reserves at December 31, 2006 from December 31, 2005 is due primarily to an increase in casualty loss and loss adjustment expense reserves primarily due to growth at Darwin. The increase in net loss and loss adjustment expense reserves for the casualty lines of business primarily reflects anticipated loss reserves on current accident year net premiums earned and limited net paid loss activity for current and prior casualty accident years. The decrease in net loss and loss adjustment expense reserves for property primarily reflects loss payments, net of reinsurance recoveries, on 2004 and 2005 hurricane related losses, partially offset by an $8.9 million net reserve adjustment related to the 2004 and 2005 hurricanes, as discussed in more detail on pages 42 and 43 of this Form 10-K Report.
representing 18.9 percent of total reinsurance recoverables, due from subsidiaries of Swiss Reinsurance Company, or “Swiss Re,” $118.0 million, representing 12.2 percent of total reinsurance recoverables, due from a subsidiary of The Chubb Corporation, or “Chubb,” and $100.6 million, representing 10.4 percent of total reinsurance recoverables, due from a subsidiary of Platinum Underwriters Holdings, Ltd., or “Platinum.” At December 31, 2007, the A.M. Best financial strength rating of each of the subsidiaries of Swiss Re and the subsidiary of Platinum was A (Excellent) or higher and A++ (Superior) for the subsidiary of Chubb. Approximately 91.6 percent of AIHL’s reinsurance recoverables balance at December 31, 2007 was due from reinsurers having an A.M. Best financial strength rating of A (Excellent) or higher. Of total reinsurance recoverable amounts, RSUI had reinsurance recoverables of approximately $791.8 million, consisting of $740.4 million of ceded outstanding losses and loss adjustment expenses and $51.4 million of recoverables on paid losses. AIHL had no allowance for uncollectible reinsurance as of December 31, 2007.
Investment Strategy. AIHL’s investment strategy seeks to preserve principal and maintain liquidity while trying to maximize its risk-adjusted, after-tax rate of return. Investment decisions are guided mainly by the nature and timing of expected liability payouts, management’s forecast of cash flows and the possibility of unexpected cash demands, for example, to satisfy claims due to catastrophic losses. AIHL’s investment portfolio currently consists mainly of highly rated and liquid debt securities and equity securities listed on national securities exchanges.
AIHL produced positive cash flow in the three-year period ending December 31, 2007, despite, with respect to 2005, significant catastrophe losses. AIHL’s positive cash flow from continuing operations reduces the need to liquidate portions of its debt securities portfolio to pay for current claims. This positive cash flow also permits AIHL, as attractive investment opportunities arise, to make investments in debt securities that have a longer duration than AIHL liabilities. This strategy, when used, is designed to grow AIHL’s capital resources. When attractive investment opportunities do not arise, AIHL may maintain higher proportions of shorter duration securities to preserve its capital resources. In this regard, as of December 31, 2007, AIHL held approximately $996.0 million, or 34.4 percent of its debt securities portfolio, in securities with maturities of five years or less and approximately $398.2 million of short-term investments. See Note 3 to the Notes to our consolidated financial statements set forth in Item 8 of this Form 10-K Report for further details
concerning the contractual maturities of our consolidated investment portfolio. AIHL may modestly increase the proportion of its debt securities portfolio held in securities with maturities of more than five years should the yields of these securities provide sufficient compensation for their increased risk. We do not believe that this strategy would reduce AIHL’s ability to meet ongoing claim payments or to respond to further significant catastrophe losses.
At December 31, 2007, AIHL’s holdings of securities backed by subprime collateral reflected no gross unrealized gains and $130 thousand of gross unrealized losses. All of such securities are rated AAA by Standard & Poor’s and rated Aaa or AAA by either Moody’s Investors Service or Fitch Ratings, respectively, and have an expected weighted average life of 1.6 years. AIHL’s holdings of securities backed by Alt-A collateral reflected $192 thousand of gross unrealized gains and $475 thousand of gross unrealized losses. 98.4 percent of such securities was rated AAA by Standard & Poor’s and rated Aaa or AAA by either Moody’s Investors Service or Fitch Ratings, respectively; with the remainder rated AA by Standard & Poor’s. The expected weighted average life of such securities is 3.9 years. All of our mortgage- and asset-backed securities are current as to principal and interest.
AIHL continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. If AIHL believes a decline in the value of a particular investment is temporary, it records the decline as an unrealized loss in common stockholders’ equity. If the decline is believed to be other than temporary, it is written down to the carrying value of the investment and a realized loss is recorded on AIHL’s statement of earnings. Management’s assessment of a decline in value includes, among other things, (i) the duration of time and the relative magnitude to which fair value of the investment has been below cost; (ii) the financial condition and near-term prospects of the issuer of the investment; (iii) extraordinary events, including negative news releases and rating
agency downgrades, with respect to the issuer of an investment; and (iv) AIHL’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. If the review indicates that the declines were other than temporary, AIHL would record a realized capital loss. In 2007, AIHL recorded $7.7 million of unrealized capital losses in its investment portfolio that were deemed to be other than temporary. Of the $7.7 million of unrealized capital losses, $6.6 million related to its mortgage- and asset-backed bond portfolio that were deemed to be other than temporary during the first quarter of 2007, and $1.1 million related to its equity portfolio that were deemed to be other than temporary during the third quarter of 2007. In 2006, AIHL recorded a realized capital loss of $3.6 million, compared with a realized capital loss of $40 thousand in 2005.
Net after-tax net investment income for the period divided by average investments for the same period.
Corporate activities recorded pre-tax earnings of $53.4 million on revenues of $90.8 million in 2007, compared with pre-tax earnings of $8.8 million on revenues of $59.8 million in 2006, and pre-tax earnings of $98.9 million on revenues of $143.9 million in 2005. Results for 2007 primarily reflect net realized capital gains at the parent level of $55.9 million resulting from the sale of approximately 809,000 shares of Burlington Northern common stock during 2007. Results for 2006 reflect $14.3 million of net realized capital gains from sales of all securities. Results for 2005 primarily reflect net realized capital gains at the parent level of $116.8 million resulting primarily from the sale of 2.0 million shares of Burlington Northern common stock.
In addition to equity securities, we also hold $117.1 million of fixed income securities at the parent level which are highly-rated, available-for-sale bonds that are primarily issued by FHLMC and FNMA. In addition, $18.3 million of high quality, short-term investments are carried at cost, which approximates market value.
Dividends. We have declared stock dividends in lieu of cash dividends every year since 1987 except 1998 when Chicago Title Corporation was spun off to our stockholders. These stock dividends have helped to conserve our financial strength and, in particular, the liquid assets available to finance internal growth and operating company acquisitions and investments. On April 25, 2008, as our dividend on our common stock for 2008, we will pay to stockholders of record on April 1, 2008 a dividend of one share of our common stock for every 50 shares outstanding.
The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement (i) requires us to, among other things, maintain Tangible Net Worth of not less than approximately $1.9 billion, maintain a ratio of Total Indebtedness to Total Capitalization as of the last day of each fiscal quarter of not greater than 0.25 to 1.0, limit the amount of certain other indebtedness and maintain certain levels of unrestricted liquid assets, and (ii) contains restrictions with respect to mortgaging or pledging any of our assets and our consolidation or merger with any other corporation. In addition, at any time when a Default or Event of Default has occurred and is continuing, the Credit Agreement prohibits us from paying any dividend or making any other distribution of any nature (cash, securities other than common stock of Alleghany, assets or otherwise), and from making any payment (whether in cash, securities or other property) on any class of our Capital Stock, and further prohibits any redemption, purchase, retirement, acquisition, cancellation, termination, or distribution by us in respect of any of the foregoing.
Common Stock Purchases. We have announced that we may purchase shares of our common stock in open market or privately negotiated transactions from time to time. In this regard, at its meeting on February 26, 2008, our Board of Directors authorized management to cause Alleghany to purchase shares of its common stock, at such times and at prices as management may determine advisable, up to an aggregate of $300 million. On March 29, 2006, we purchased an aggregate of 139,000 shares of our common stock for approximately $39.2 million, at an average cost of about $281.91 per share (not adjusted for the subsequent stock dividend), in a privately negotiated transaction. In 2007 and 2005, we did not purchase any shares of our common stock. As of December 31, 2007, we held no shares of treasury stock.
Dividends from Subsidiaries. At December 31, 2007, approximately $412.2 million of the equity of all of our subsidiaries was available for dividends or advances to us at the parent level. At that date, approximately $2.0 billion of our total equity of $2.79 billion was unavailable for dividends or advances to us from our subsidiaries. With respect to AIHL’s insurance operating units, they are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid by them without prior approval of insurance regulatory authorities. Of the aggregate total equity of our insurance operating units at December 31, 2007 of $2.17 billion, a maximum of $169.9 million was available for dividends without prior approval of the applicable insurance regulatory authorities. These limitations have not affected our ability to meet our obligations. In 2007, RSUI paid us a cash dividend of $75.0 million, CATA paid us a cash dividend of $12.0 million, AIHL Re paid us a dividend of $70.0 million and Alleghany Properties paid us a cash dividend of $12.0 million. In 2006, CATA paid us a cash dividend of $15.0 million and Alleghany Properties paid us a cash dividend of $11.5 million. In 2005, RSUI paid us a cash dividend of $25.0 million.
At December 31, 2007, AIHL had total unpaid losses and loss adjustment expenses of approximately $2.6 billion and total reinsurance recoverables of approximately $967.5 million, consisting of $915.3 million of ceded outstanding losses and loss adjustment expenses and $52.2 million of recoverables on paid losses. As of December 31, 2007, AIHL’s investment portfolio had a fair market value of $4.1 billion and consisted
On May 2, 2005, DNA acquired Darwin Select for cash consideration of approximately $25.3 million, $22.3 million of which represented consideration for Darwin Select’s investment portfolio and the balance of which represented consideration for licenses. This acquisition was funded from internal cash resources. In June 2006, AIHL made a capital contribution of $50.0 million to AIHL Re to provide catastrophe reinsurance coverage for RSUI through AIHL Re. On December 29, 2006, AIHL acquired approximately 32.9 percent of the outstanding shares of common stock of Homesite for $120.7 million in cash. On July 18, 2007, AIHL acquired approximately 98.4 percent of the outstanding shares of common stock of EDC for $198.1 million. AIHL made a capital contribution of $50.0 million to EDC in connection with the acquisition of EDC.
On March 26, 2007, Darwin entered into an agreement with JPMorgan Chase Bank, National Association for a $25 million revolving credit facility. The credit facility is for a three year term. The cost of funds drawn down is an annual interest rate of LIBOR + 1.125 percent. As of December 31, 2007, Darwin had used $5.0 million of this $25.0 million revolving credit facility. Darwin’s obligations under this credit facility are not backed by Alleghany.
Alleghany Properties. As part of our sale of Sacramento Savings Bank in 1994, we, through our wholly-owned subsidiary Alleghany Properties, purchased the real estate and real estate-related assets of Sacramento Savings. Alleghany Properties is our only subsidiary holding substantial real estate investments. As of December 31, 2007, Alleghany Properties held properties having a total book value of $20.1 million, compared to $22.6 million as of December 31, 2006 and $27.5 million as of December 31, 2005. These properties and loans had a total book value of approximately $90.1 million as of October 31, 1994, the date Alleghany Properties purchased the assets. The capital needs of Alleghany Properties consist primarily of various development costs relating to its owned properties and corporate administration. Adequate funds to provide for the currently foreseeable needs of its business are expected to be generated by sales and, if needed, capital contributions by us. Alleghany Properties paid cash dividends to us of $12.0 million and $11.5 million in 2007 and 2006, respectively.
In July 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” was issued. This Interpretation clarifies the accounting for income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a
Alleghany also owned World Minerals, Inc. (“World Minerals”) until its disposition on July 14, 2005. Accordingly, the operations of World Minerals have been reclassified as a discontinued operation for all periods presented. See Note 2. Alleghany no longer has any foreign operations as a result of its disposition of World Minerals.
In the 2007 second quarter, Alleghany determined that it had incorrectly classified operating payments made from its investing accounts as an investing cash flow activity in its consolidated statements of cash flows. These operating payment amounts should have been classified as outflows from operating activities. As a result, for the twelve-month period ended December 31, 2006 and December 31, 2005, cash outflows in the amount of $0.3 million and $26.9 million, respectively, were reclassified from cash flows used in investing activities to cash flows used in operating activities. A similar correction to cash flows will also be made in future reports for the three-month period ended March 31, 2007 in the amount of $11.6 million. These corrections are not material to Alleghany’s consolidated financial statements.
During the 2007 fourth quarter, Alleghany identified an error representing the over-accrual of current taxes payable for periods prior to January 1, 2003. In order to correct this historical error, Alleghany recorded the following immaterial corrections to prior period financial statement amounts: (a) a cumulative increase of approximately $26.1 million to opening retained earnings in the consolidated statement of shareholders’ equity for the year ended December 31, 2005; and (b) a comparable decrease in current taxes payable in the consolidated statement of condition at December 31, 2006.
Investments consist of equity securities, debt securities, short-term investments and other invested assets. Alleghany classifies its marketable equity securities, debt securities and short-term investments as available for sale. Debt securities consist of securities with an initial fixed maturity of more than one year. Short-term
Realized gains and losses on investments are determined in accordance with the specific identification method.
Other invested assets include strategic equity investments in operating companies which are accounted for under the equity method and partnership investments which are accounted for as either available-for-sale or equity-method investments.
AIHL’s insurance operating units follow the customary practice of reinsuring with other companies a portion of the loss exposures on business AIHL’s insurance operating units have written. This practice allows
Acquisition costs related to unearned premiums that vary with, and are directly related to, the production of such premiums (principally commissions, premium taxes, compensation and certain other underwriting expenses) are deferred. Deferred acquisition costs are amortized to expense as the related premiums are earned. Deferred acquisition costs are periodically reviewed to determine their recoverability from future income, including investment income, and if any such costs are determined to be not recoverable they are charged to expense. Deferred acquisition costs amortized to expense in 2007 and 2006 were $172.8 million and $142.0 million, respectively.
Goodwill and certain intangible assets deemed to have an indefinite useful life are subject to an annual review for impairment. During 2007, Alleghany performed impairment tests using the fair value approach required by Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” Based on these tests, there was no impairment to goodwill or intangible asset values during 2007. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives.
With respect to stock option grants, the fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Common Stock. Alleghany uses historical data to estimate
option exercise and employee termination within the valuation model. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
In March 2006, FASB Statement No. 155, “Accounting for certain Hybrid Instruments, an amendment to FASB Statement No. 133 and 140,” was issued. This Statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Alleghany has adopted the provisions of this Statement as of January 1, 2007, and the implementation did not have any material impact on its results of operations and financial condition.
In July 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” was issued. This Interpretation clarifies the accounting for income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. Alleghany has adopted the provisions of this Interpretation as of January 1, 2007, and the implementation did not have any material impact on its results of operations and financial condition.
In February 2007, FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115,” was issued. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value, at specified election dates, with unrealized gains and losses reported in earnings at each subsequent reporting date. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, “Fair Value Measurements.” Alleghany has adopted the provisions of this Statement as of January 1, 2008, and the implementation did not have any material impact on its results of operations and financial condition.
At July 14, 2005, Alleghany’s investment in World Minerals was $182.9 million. Historical information relating to the results of operations of World Minerals is as follows (in millions):
Alleghany continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. If Alleghany believes a decline in the value of a particular investment is temporary, it records the decline as an unrealized loss in common stockholders’ equity. If the decline is believed to be other-than-temporary, it is written down to the carrying value of the investment and a realized loss is recorded on Alleghany’s statement of earnings. Management’s assessment of a decline in value includes, among other things, (i) the duration of time and the relative magnitude to which fair value of the investment has been below cost; (ii) the financial condition and near-term prospects of the issuer of the investment; (iii) extraordinary events, including negative news releases and rating agency downgrades, with respect to the issuer of an investment; and (iv) Alleghany’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. If that judgment changes in the future, Alleghany may ultimately record a realized loss after having originally concluded that the decline in value was temporary. If the review indicates that the declines were other-than-temporary, Alleghany would record a realized capital loss. A debt security is impaired if it is probable that Alleghany will not be able to collect all amounts due under the security’s contractual terms. An equity investment is impaired when it becomes apparent that Alleghany will not recover its cost over the expected holding period. Further, for securities expected to be sold, an other-than-temporary impairment charge is
recognized if Alleghany does not expect the fair value of a security to recover its cost upon sale. In 2007, Alleghany recorded a realized capital loss of $7.7 million, compared with realized capital losses of $4.7 million and $40 thousand in 2006 and 2005, respectively. Of the $7.7 million of realized capital losses in 2007, $6.6 million of such losses related to mortgage- and asset-backed bond portfolio losses that were deemed to be other-than-temporary during the first quarter of 2007, and $1.1 million related to equity portfolio losses that were deemed other-than-temporary during the third quarter of 2007.
Notes receivable was comprised of a $91.5 million note due January 22, 2007 bearing interest at a rate equal to the 30-day commercial paper rate plus 0.0625 percent. At December 31, 2006, such rate was 5.25 percent. This note fully secured the borrowings of Alleghany Funding Corporation (“Alleghany Funding”), a wholly-owned subsidiary of Alleghany, and matured on January 22, 2007. See Note 7.
In connection with the acquisition by Alleghany of Platte River in 2002 and the acquisition by RSUI Indemnity Company (“RIC”), a wholly-owned subsidiary of RSUI, of Landmark American Insurance Company (“Landmark”) in 2003 (discussed in more detail below), the sellers contractually retained all of the loss and loss adjustment expense liabilities. These contractual provisions constituted loss reserve guarantees as contemplated under EITF D-54, “Accounting by the Purchasers for a Seller’s Guaranty of the Adequacy of Liabilities for Losses and Loss Adjustment Expenses of an Insurance Enterprise Acquired in a Purchase Business Combination.” On January 3, 2002, Alleghany acquired Platte River from Swiss Re pursuant to a Stock Purchase Agreement dated as of December 5, 2001, and transferred Platte River to AIHL pursuant to a Contribution Agreement dated January 3, 2002. The Stock Purchase Agreement provides that Swiss Re shall indemnify and hold harmless Alleghany, AIHL and Platte River and their respective directors, officers and employees from and against any and all liabilities arising out of binders, policies and contracts of insurance issued by Platte River to the date of closing under the Stock Purchase Agreement. AIHL recorded a reinsurance recoverable and a corresponding loss reserve liability in the amount of $181.3 million at the time it acquired Platte River. Such reinsurance recoverables and loss reserve liability may change as losses are reported. Such amounts were
$28.7 million, $32.7 million and $51.6 million for Platte River at December 31, 2007, 2006 and 2005, respectively.
The following table indicates property and casualty premiums written and earned for the years ended December 31, 2007, 2006, and 2005 (in thousands):
Ceded loss recoveries for AIHL included in Alleghany’s consolidated statements of earnings were approximately $258.0 million, $282.5 million and $1.3 billion at December 31, 2007, 2006, and 2005, respectively.
RSUI reinsures its property lines of business through a program consisting of surplus share treaties, facultative placements, per risk and catastrophe excess of loss treaties. Under its surplus share treaties, which generally provide coverage on a risk attaching basis (the treaties cover policies which become effective during the treaty coverage period) from January 1 to December 31, RSUI is indemnified on a pro rata basis against covered property losses. The amount indemnified is based on the proportionate share of risk ceded after consideration of a stipulated dollar amount of “line” for RSUI to retain in relation to the entire limit written. RSUI ceded approximately 30 percent of its property gross premiums written in 2007 under these surplus share treaties. Under RSUI’s property per risk reinsurance program, which generally provides coverage on an annual basis for losses occurring from May 1 to the following April 30, RSUI is reinsured for $90.0 million in
excess of a $10.0 million net retention per risk after the application of the surplus share treaties and facultative reinsurance.
RSUI’s catastrophe reinsurance program (which covers catastrophe risks including, among others, windstorms and earthquakes) and per risk reinsurance program run on an annual basis from May 1 to the following April 30. RSUI, due to its reduction in exposed limits since May 1, 2006, sought a lesser amount of catastrophe reinsurance at its 2007 renewal. In this regard, RSUI’s catastrophe reinsurance program for 2007-2008 covers $400.0 million of losses, before a 17.5 percent co-participation by RSUI, in excess of a $100.0 million net retention after application of the surplus share treaties, facultative reinsurance and per risk covers, compared with coverage for $675.0 million of losses, before a 5.0 percent co-participation by RSUI, in excess of a $75.0 million net retention under the expired program. As discussed below, because AIHL Re, a wholly-owned subsidiary of AIHL, provided coverage under this program, there was no net reduction in Alleghany’s catastrophe exposure on a consolidated basis as a result of RSUI’s arrangement with AIHL Re. RSUI’s property per risk reinsurance program for the 2007-2008 period provides RSUI with reinsurance for $90.0 million of losses in excess of $10.0 million net retention per risk after application of the surplus share treaties and facultative reinsurance, which is substantially similar to the expired program.
AIHL Re and Homesite entered into a reinsurance agreement, effective April 1, 2007, whereby AIHL Re, in exchange for annual premium of approximately $2.0 million, provides $20.0 million of excess-of-loss reinsurance coverage to Homesite under its catastrophe reinsurance program. To secure AIHL Re’s obligations to make payments to Homesite under the April 1, 2007 agreement, a deposit of approximately $20.0 million has been made into a trust fund established for the benefit of Homesite.
Darwin’s reinsurance program provides coverage for $10.0 million of losses, before a 15 percent co-participation by Darwin, in excess of a $1.0 million net retention, with ceding commissions varying depending upon profitability. For Darwin’s non-medical lines of business, Darwin’s reinsurance program provides coverage in layers. The first layer applies to all lines, other than commercial and healthcare D&O and financial institutions and managed care E&O, and provides coverage for $1.0 million of losses, before a 25 percent Darwin co-participation, in excess of a $1.0 million retention. The next layer, for all professional, managed care and shortline railroad liability lines, covers $3.0 million of losses, before a 25 percent co-participation by Darwin, in excess of a $2.0 million net retention. The third layer provides coverage for up to $10.0 million of losses, before a 15 percent co-participation by Darwin, in excess of $5.0 million of losses for non-publicly traded D&O liability (other than Side-A only liability) and primary insurance agents E&O liability and for $5.0 million of losses for other non-medical lines, before a 15.0 percent co-participation by Darwin, in excess of $5.0 million of losses. The last layer provides coverage for $5.0 million of losses for Darwin’s Side-A only D&O liability, before a 10 percent co-participation by Darwin, in excess of $15.0 million of losses, and for $10.0 million of losses for managed care E&O, before a 10 percent co-participation by Darwin, in excess of $10.0 million of losses. As with Darwin’s medical reinsurance program, premiums do not vary depending on profitability, but ceding commissions may vary.
EDC uses reinsurance to protect against catastrophe losses. In 2007, EDC retained the first $1.0 million of loss per occurrence and bought reinsurance with various reinsurers for $149.0 million above that level. Any loss above $150.0 million would be the sole responsibility of EDC. All of EDC’s 2007 reinsurance includes foreign and domestic terrorism coverage, although nuclear, chemical, biological and radiological events are excluded. By law, EDC cannot exclude any form of terrorism from its workers’ compensation policies.
Total gross loss adjustment expense reserves increased by $275.5 million during 2007, from $2,304.6 million to $2,580.1 million. Of this increase, $556.0 million was due to the casualty lines of business (including workers’ compensation), primarily reflecting the acquisition of EDC during 2007, as well as increased earned premium in D&O liability, medical malpractice and professional liability, combined with limited paid loss activity for the current and prior casualty accident years. The $556.0 million was partially offset by a decrease in the reserves of the property lines of business, primarily reflecting a decrease in RSUI’s losses and loss adjustment expenses connected to the 2005 hurricane activity, as payments were made by RSUI during 2007, and reinsurance recoveries were received during 2007.
The above reserve changes included adjustments to prior year reserves. For RSUI, net prior year property reserves were increased by $43.2 million in 2007 and $8.9 million in 2006 related primarily to its 2005 Hurricane Katrina reserve estimates. The 2007 increase reflects the results of a review of Katrina loss and loss adjustment expense reserves in light of the current uncertain legal environment. RSUI reviews its reserves quarterly. In the second quarter of 2007, settlements of pending claims were larger than expected, which contributed to RSUI’s decision to increase reserves for its remaining pending Hurricane Katrina claims. Future legal developments, to the extent adverse to the insurance industry, may result in additional adverse development in RSUI’s Hurricane Katrina loss and loss adjustment expense reserves. The 2006 increase was due to a change in the composition of estimated ceded losses. Such adjustment reflected a review completed by RSUI during the 2006 fourth quarter of reinsurance cessions with respect to Hurricane Katrina that showed RSUI’s net retained losses would be slightly higher than previously estimated. The Hurricane Katrina
In addition, RSUI’s net prior year casualty reserves were increased by $34.7 million in 2007. This adjustment was for the professional liability and D&O liability lines of business, and reflected favorable loss emergence assumed in earlier periods. For CATA, net prior year reserves were reduced by $14.4 million and $13.6 million in 2007 and 2006, respectively. The releases primarily reflect favorable loss emergence principally in its casualty and commercial surety lines of business. For Darwin, net prior year reserves, together with a corresponding amount of ceded premium reserves, were reduced by $21.2 million and $4.0 million in 2007 and 2006, respectively. In light of Darwin’s lack of meaningful claims history, industry data was initially used in estimating reserves. Beginning in 2006 and continuing into 2007, Darwin began to recognize favorable claims emergence on prior accident years, as industry data was gradually replaced with Darwin’s own claims experience.
For EDC, net prior year workers’ compensation reserves were decreased in 2007 by $9.7 million, consisting of an $18.8 million decrease for prior accident years, partially offset by a $9.1 million increase for the 2007 year through the date of EDC’s acquisition by AIHL. The reduction for prior years reflects favorable loss emergence as compared with the loss emergence assumed in earlier years. The increase for 2007 through the date of acquisition reflects unfavorable loss emergence patterns as compared with the loss emergence assumed in the period prior to the acquisition.
Regarding Alleghany’s interest rate swaps, the impact of Alleghany’s hedging activities had been to increase its weighted average borrowing rates by 0.13 percent and 0.11 percent, and to increase reported interest expense by $104 thousand and $89 thousand for the years ended 2006 and 2005, respectively. Alleghany did not utilize interest rate swaps in 2007.
As described in Note 2, Alleghany sold World Minerals on July 14, 2005. As a result of the sale and Section 338(h)(10) election, Alleghany was able to retain certain tax benefits, including an estimated foreign tax credit carryover generated by World Minerals. In the first quarter of 2006, Alleghany adopted and implemented a formal plan which it believed would allow it to fully use such credits commencing in 2007, at which time a $10.8 million net benefit was recorded to earnings. Based on an analysis of its foreign tax credits and related information completed in the fourth quarter of 2007, Alleghany adjusted its estimate of foreign tax credits and recorded a net tax adjustment of $5.2 million.
The foreign tax credits expire between tax years 2009 and 2014. A valuation allowance is provided against deferred tax assets when it is more likely than not that some portion of the deferred tax asset will not be realized. In the opinion of Alleghany’s management, realization of the remaining net deferred tax asset related to foreign tax credits of $4.8 million remain highly certain based on expectations as to Alleghany’s future taxable income and foreign source income.
In 2006, Alleghany recognized $13.9 million of additional deferred tax assets for state net operating loss carryovers. A valuation allowance of $13.9 million was established since Alleghany does not currently anticipate generating sufficient income in the various states to absorb these loss carryovers.
Alleghany’s 2004 and 2005 income tax returns are currently under examination by the Internal Revenue Service, and Alleghany’s 2006 income tax return remains open to examination.
On May 24, 2006, Darwin closed the initial public offering of its common stock. In the offering, Darwin sold 6.0 million shares of common stock for net proceeds of $86.3 million, all of which were used to reduce Alleghany’s equity interests in Darwin by redeeming Darwin preferred stock held by Alleghany. Upon completion of the offering, all remaining unredeemed shares of Darwin preferred stock automatically converted to shares of Darwin common stock. Alleghany continues to own approximately 55 percent of the total outstanding shares of common stock of Darwin (with no preferred stock outstanding). In connection with this transaction, Alleghany recorded an after-tax gain of $9.5 million, which is reflected in “Contributed Capital.” The portion of Darwin not owned by Alleghany is reflected on Alleghany’s consolidated balance sheet and income statement as a minority interest liability and expense, respectively.
The Board of Directors has authorized the purchase from time to time of shares of Common Stock for the treasury. No shares were repurchased in 2007. On March 29, 2006, Alleghany purchased an aggregate of 139,000 shares of Common Stock for approximately $39.2 million, at an average cost of about $281.91 per share (not adjusted for subsequent stock dividends), in a privately negotiated transaction. As of December 31, 2007, Alleghany held no shares of treasury stock.
of insurance regulatory authorities. Of the aggregate total equity of Alleghany’s insurance operating units at December 31, 2007 of $2.17 billion, a maximum of $169.9 million was available for dividends without prior approval of the applicable insurance regulatory authorities. Additionally, payments of dividends (other than stock dividends) by Alleghany to its stockholders are permitted by the terms of its Credit Agreement provided that Alleghany maintains certain financial ratios as defined in the Credit Agreement. At December 31, 2007, approximately $603.0 million of stockholders’ equity was available for dividends by Alleghany to its stockholders.
Amounts recognized as compensation expense in the consolidated statements of earnings and comprehensive income with respect to share-based awards under plans for parent-level employees and non-employee directors were $11.0 million, $14.3 million and $16.7 million in 2007, 2006 and 2005, respectively. The amount of related income tax benefit recognized as income in the consolidated statements of earnings and comprehensive income with respect to these plans was $3.9 million, $5.0 million, $5.8 million in 2007, 2006 and 2005, respectively. In 2007, 2006 and 2005, $18.5 million, $6.0 million and $6.6 million of Common Stock, at fair market value, respectively, and $13.2 million, $3.5 million and $6.8 million of cash, respectively, was paid by Alleghany under plans for parent-level employees and non-employee directors. As noted above, as of December 31, 2007 and December 31, 2006, all outstanding awards were accounted for under the fair value based method of accounting. However, under the prospective transition method, not all outstanding awards were accounted for under the fair value based method of accounting as of December 31, 2005. The table below illustrates the effect for 2005 had the fair value method been adopted with respect to all outstanding and unvested awards under all plans for parent-level employees and non-employee directors (in thousands, except per share data):
Alleghany provided, through its Amended and Restated Directors’ Stock Option Plan (under which options were granted through May 1999) and its 2000 Directors’ Stock Option Plan (which expired on December 31, 2004), for the automatic grant of non-qualified options to purchase 1,000 shares of Common Stock in each year after 1987 to each non-employee director. Currently, Alleghany’s 2005 Directors’ Stock Plan (the “2005 Plan”) provides for the automatic grant of nonqualified options to purchase 500 shares of Common Stock, as well as an automatic grant of 250 shares of restricted Common Stock or, upon the election of a non-employee director, restricted stock units, to each non-employee director on an annual basis. In 2007 and 2006, Alleghany awarded a total of 2,250 restricted shares and units and 2,000 restricted shares, respectively, which vest over a one-year period.
A summary of option activity under the above plans as of December 31, 2007, and changes during the year then ended is presented below:
The weighted-average grant-date fair value of options granted during the years 2007, 2006 and 2005, was $139.05, $91.52 and $93.35, respectively. The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005, was $2.2 million, $2.4 million, and $2.2 million, respectively.
As of December 31, 2007, there was $0.7 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the 2005 Plan. That cost is expected to be recognized over a weighted-average period of approximately one year. The total fair value of shares vested
(i) Performance Share Awards - Participants are entitled, at the end of a four-year award period, to a maximum amount equal to the value of one and one-half shares of Common Stock for each performance share issued to them based on market value on the payment date. In general, performance share payouts will be made in cash to the extent of minimum statutory withholding requirements in respect of an award, with the balance in Common Stock. Payouts are made provided defined levels of performance are achieved. As of December 31, 2007, 86,627 performance shares were outstanding. Expense is recognized over the performance period on a pro rata basis.
Darwin has four share-based payment plans for employees and non-employee directors. The 2003 Restricted Stock Plan (as amended November 2005), and the 2006 Stock Incentive Plan apply to key employees. The 2006 Employees’ Restricted Stock Plan applies to all employees, except certain key employees, at the time of Darwin’s initial public offering. Finally, the Unit Plan for Non-employee Directors
applies to non-employee directors. Collectively, the shares issued under these plans had a nominal fair value at the date of grant, and consequently, resulted in nominal increases in Alleghany’s compensation expense.
The following tables set forth the defined benefit plans’ funded status at December 31, 2007 and 2006 and total cost for each of the three years ended December 31, 2007 (in millions, except percentages):
Contributions of less than $0.1 million are expected to be made to Alleghany’s funded employee plan during 2008.
The measurement date used to determine pension benefit plans is December 31, 2007.
Alleghany has two unfunded retiree health plans, one for executives and one for employees. To be eligible for benefits participants must be age 55 or older. In addition, non-executive employees must have completed at least 10 years of service. Under the plans, participants must pay a portion of the premiums charged by the medical insurance provider. All benefits cease upon retiree death. RSUI also has an unfunded retiree health plan for its employees. As of December 31, 2007 and December 31, 2006, the liability for both of these plans was $4.1 million and $3.8 million, respectively, representing the entire accumulated postretirement benefit obligation as of that date. Assumptions used on the accounting for these plans are comparable to those cited above for the Alleghany pension plans. Future benefit payments associated with these plans are not expected to be material to Alleghany.
Alleghany provides supplemental retirement benefits through deferred compensation programs and profit sharing plans for certain of its officers and employees. In addition, Alleghany’s subsidiaries sponsor both qualified defined contribution retirement plans for substantially all employees, including executives, and non-qualified plans only for executives, both of which provide for voluntary salary reduction contributions by employees and matching contributions by each respective subsidiary, subject to specified limitations.
Alleghany had an unfunded noncontributory defined benefit pension plan for non-employee directors. On December 19, 2006, the Board of Directors amended the plan to permit directors who were serving as directors on December 31, 2004 to make an election before the end of 2006 to receive an actuarially determined lump-sum payout of their accrued benefit in 2007. All eligible directors made this election, and accordingly, at December 31, 2006 Alleghany accrued $1.0 million of liabilities. Such amount was paid to directors in 2007.
The incremental effect of Alleghany’s adoption of SFAS 158 as of December 31, 2006 was an increase in other liabilities of $4.9 million, a decrease in deferred tax liabilities of $1.7 million, and a reduction of additional other comprehensive income of $3.2 million, after-tax. The $3.2 million represents the current underfunded status of all of Alleghany’s defined benefit pension plans ($2.7 million) and retiree health plans ($0.5 million) as of that date.
During the Alleghany Period, World Minerals was named in approximately 30 lawsuits that included product liability claims, many of which have been voluntarily dismissed by the plaintiffs. In most cases, plaintiffs claimed various medical problems allegedly stemming from their exposure to a wide variety of allegedly toxic products at their place of employment, and World Minerals was one among dozens of
At December 31, 2007 and 2006, Alleghany had a concentration of market risk in its available-for-sale equity securities portfolio of Burlington Northern Santa Fe Corporation (“Burlington Northern”), a railroad holding company, of $416.2 million and $428.8 million, respectively. In January and February of 2007, Alleghany sold approximately 809 thousand shares of its Burlington Northern stock holdings for approximately $65 million of proceeds. In February of 2008, Alleghany sold approximately 431 thousand shares of its Burlington Northern stock holdings for approximately $38.9 million of proceeds.
At December 31, 2007 and 2006, Alleghany also had a concentration of market risk in its available-for-sale equity securities with respect to certain energy sector businesses, of $378.2 million and $280.9 million, respectively.
Swap: The fair value of the swap was based on a valuation model.
Subsidiaries’ debt: The fair value of the subsidiaries’ debt is estimated to approximate carrying value.
The primary components of “corporate activities” are Alleghany Properties, AIHL’s investment in Homesite, corporate investment and other activities at the parent level, including strategic equity investments. Such strategic equity investments are available to support the internal growth of subsidiaries and for acquisitions of, and substantial investments in, operating companies.
Includes the results of EDC, net of purchase accounting adjustments, commencing July 18, 2007.
Includes $4.1 million of Alleghany’s equity in earnings of Homesite, net of purchase accounting adjustments, for the twelve months ended December 31, 2007 (See Note 16).
Net realized capital gains for 2007 primarily reflect net realized capital gains from the sale of approximately 809,000 shares of Burlington Northern common stock in the 2007 first quarter.
Represents net premiums earned less loss and loss adjustment expenses and underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income and other income or net realized capital gains. Underwriting expenses represent commission and brokerage expenses and that portion of salaries, administration and other operating expenses directly attributable to underwriting activities, whereas the remainder constitutes “other expenses.”
The acquisition has been accounted for by the purchase method of accounting in accordance with SFAS 141, and therefore, the assets acquired and liabilities assumed have been recorded at their estimated fair values at the Acquisition Date. Any excess of the purchase price over the estimated fair values of the assets acquired, including identifiable intangible assets and liabilities assumed, is recorded as goodwill. Although Alleghany has not finalized the allocation of the purchase price at this time, it currently estimates goodwill, which is not deductible for tax purposes, of approximately $48.8 million and other intangible assets of approximately $13.9 million. Acquired identifiable intangible assets include trade names and licenses, which were determined to have indefinite useful lives. Acquired identifiable assets also include renewal rights, distribution rights and database development, which are being amortized over the estimated useful lives of ten years, ten years, and twenty years, respectively. The net impact of amortization expenses and purchase
accounting on Alleghany’s net income is not material. The estimated fair value of assets acquired, including identifiable intangible assets, and liabilities assumed at the Acquisition Date is as follows (in millions):
Substantially all of EDIC’s equity was unavailable for dividends or advances to Alleghany without prior approval of the California Department of Insurance.
The economical useful lives of intangible assets are as follows: agency relationships - 15 years; state insurance licenses - indefinite; trade name - indefinite; broker and reinsurance relationships - 15 years; and renewal and distribution rights - between 5 and 10 years.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alleghany Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
We have audited Alleghany Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Alleghany Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings and comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated February 25, 2008 expressed an unqualified opinion on those consolidated financial statements.