| ARGONAUT GROUP INC Item 1A Risk Factors An investment in the Company’s common stock involves various risks, including those mentioned below and those that are discussed from time-to-time in our other periodic filings with the Commission |
| Investors should carefully consider these risks, along with the other information contained in this report, before making an investment decision regarding our common stock |
| There may be additional risks of which the Company is currently unaware, or which we currently consider immaterial |
| All of these risks could have a material adverse effect on our financial condition, results of operations, and value of our common stock |
| Our results may fluctuate based on many factors, including cyclical changes in the insurance industry |
| The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties |
| The industry’s profitability can be affected significantly by: • rising levels of claim costs that are not known by companies at the time they price their products; 16 ______________________________________________________________________ [57]Table of Contents [58]Index to Financial Statements • volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes; • changes in reserves resulting from the claims and legal environments as different types of claims arise and judicial interpretations relating to the scope of insurers’ liability develop, including particularly with respect to workers’ compensation, asbestos and environmental claims; and • fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested capital and may impact the ultimate payout of losses |
| The property and casualty insurance industry is cyclical |
| The demand for property and casualty insurance can vary significantly, generally rising as the overall level of economic activity increases and falling as such activity decreases |
| The property and casualty insurance industry and the reinsurance business are also very competitive |
| During the late 1990s and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns |
| Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990s and into 2000 |
| These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001 |
| Rate increases continued through 2003 and to a lesser extent in 2004, and the industry’s underwriting results have improved |
| The pricing environment during 2005 experienced downward pressure, particularly for larger accounts |
| The hurricane activity during the third quarter of 2005 may result in higher rates for certain property business while reinsurance costs are expected to increase for property catastrophe reinsurance protection but currently the Company is unable to estimate the impact this may have on its financial results, if any |
| Competition for profitable business in the past has resulted in pressure on pricing and less restrictive terms and conditions, contributing to the cyclical pricing and underwriting results |
| These fluctuations in demand and competition and the impact on us of other factors identified above could have a material adverse effect on our business, results of operations and/or financial condition |
| Legislation and regulatory changes and increased competition could also adversely impact our results |
| A number of new, proposed or potential legislative or industry developments could further increase competition in our industry |
| These developments could include: • an influx of new capital in the marketplace as existing companies attempt to expand their businesses and new companies attempt to enter the insurance and reinsurance business as a result of better pricing and/or terms; • the enactment of the Gramm-Leach-Bliley Act of 1999 (which permits financial services companies, such as banks and brokerage firms, to engage in certain insurance activities), which could result in increased competition from financial services companies; • programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative markets types of coverage; and • changing practices caused by the Internet, which have led to greater competition in the insurance business |
| These developments and others could make the property and casualty insurance marketplace more competitive by increasing the supply of insurance and reinsurance available |
| The significant amount of capital in the property and casualty marketplace has, until recently, resulted in the supply of insurance and reinsurance outpacing demand |
| The property and casualty insurance industry is characterized by a large number of competing companies and modest market shares for industry participants |
| According to AM Best Company, or AM Best, generally considered to be the leading insurance industry rating and analysis firm, as of December 31, 2004, there were approximately 2cmam500 property and casualty insurance companies operating in the United States |
| We and our insurance subsidiaries ranked among the 250 largest property and casualty insurance company organizations in the United States, measured by net premiums written (83^rd), and policyholder’s surplus (92^nd) |
| 17 ______________________________________________________________________ [59]Table of Contents [60]Index to Financial Statements Our principal competitors cannot be easily classified |
| Our principal lines of business are written by numerous other insurance companies |
| Competition for any one account may come from very large national firms or smaller regional companies |
| For our workers’ compensation lines, additional competition comes from state workers’ compensation funds |
| Property and casualty insurance is a highly competitive business, particularly with respect to excess and surplus lines, commercial lines and workers’ compensation insurance |
| Over the past several years, competition has become more intense, due to the efforts of many insurance companies to obtain, maintain and expand market share by offering relatively low premium rates |
| Competition has grown from established companies and the entry of new competitors into the industry |
| All states have enacted legislation that regulates insurance holding companies such as us and our subsidiaries |
| This legislation generally provides that each insurance company in the holding company is required to register with the department of insurance of its state of domicile and furnish information concerning the operations of companies within the holding company system which may materially affect the operations, management or financial condition of the insurers within the group |
| Such regulation generally provides that transactions between companies within the holding company system must be fair and equitable |
| Transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries and certain material transactions between companies within the system may be subject to prior notice to, or prior approval by, state regulatory authorities |
| If our actual losses from insureds exceed our loss reserves, our financial results would be adversely affected |
| We record reserves for specific claims incurred and reported and reserves for claims incurred but not reported |
| The estimates of losses for reported claims are established judgmentally on an individual case basis |
| Such estimates are based on our particular experience with the type of risk involved and our knowledge of the circumstances surrounding each individual claim |
| Reserves for reported claims consider our estimate of the ultimate cost to settle the claims, including investigation and defense of the claim, and may be adjusted for differences between costs originally estimated and costs re-estimated or incurred |
| Reserves for incurred but not reported claims are based on the estimated ultimate cost of settling claims, including the effects of inflation and other social and economic factors, using past experience adjusted for current trends and any other factors that would modify past experience |
| We use a variety of statistical and actuarial techniques to analyze current claim costs, frequency and severity data, and prevailing economic, social and legal factors |
| While management believes that amounts included in the consolidated financial statements are adequate, there can be no assurance that future changes in loss development, favorable or unfavorable, will not occur |
| The estimates are periodically reviewed and any changes are reflected in current operations |
| Our objective is to set reserves that are adequate and represent management’s best estimate; that is, the amounts originally recorded as reserves should at least equal the ultimate cost to investigate and settle claims |
| However, the process of establishing adequate reserves is inherently uncertain, and the ultimate cost of a claim may vary materially from the amounts reserved |
| The reserving process is particularly imprecise for claims involving asbestos, environmental and other long-tailed exposures (those exposures for which claims take a long time to develop or for which the amount of claims payments are not known for a long period of time) now confronting property and casualty insurers |
| We regularly monitor and evaluate loss and loss adjustment expense reserve development to verify reserve adequacy |
| Any adjustment to reserves is reflected in underwriting results for the accounting period in which the adjustment is made |
| We have received asbestos and environmental liability claims arising out of general liability coverage primarily written in the 1970’s and into the mid-1980’s |
| We have established a specialized claims unit that investigates and adjusts asbestos and environmental claims |
| Beginning in 1986, nearly all standard liability policies contained an express exclusion for asbestos and environmental related claims |
| In the third quarter of 2002, we increased our reserve for losses and loss adjustment expenses by approximately dlra7dtta0 million for certain policies issued in one office subsequent to 1986 that did not contain this exclusion |
| Currently, we are not aware of any additional policies issued after 1986 without this exclusion |
| Through our subsidiary, Rockwood, we have exposure to claims for black lung disease |
| Those diagnosed with black lung disease are eligible to receive workers’ compensation benefits from various federal and state programs |
| These programs are continually being reviewed by the governing bodies and may be revised without notice in such a way as to increase the level of our exposure |
| In addition to the previously described general uncertainties encountered in estimating reserves, there are significant additional uncertainties in estimating the amount of our 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: • potentially long waiting periods between exposure and emergence of any bodily injury or property damage; 18 ______________________________________________________________________ [61]Table of Contents [62]Index to Financial Statements • difficulty in identifying sources of environmental or asbestos contamination; • difficulty in properly allocating responsibility and/or liability for environmental or asbestos damage; • changes in underlying laws and judicial interpretation of those laws; • potential for an environmental or asbestos claim to involve many insurance providers over many policy periods; • long reporting delays from insureds to insurance companies; • historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of claims; • questions concerning interpretation and application of insurance coverage; and • uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure |
| Management believes that these factors continue to render traditional actuarial methods less effective at estimating reserves for asbestos and environmental losses than reserves on other types of losses |
| We currently underwrite environmental and pollution coverages (on a limited number of policies) and underground storage tanks |
| We establish reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company not dissimilar to those results the industry has experienced with regard to asbestos and environmental related claims |
| We annually review our loss and loss adjustment expense reserves for our run-off lines of business, including our asbestos and environmental claims |
| The review entails a detailed analysis of our direct and assumed exposure |
| We engage a consulting actuary to assist us in determining a best estimate of ultimate losses and our management evaluates that estimate in assessing the adequacy of the run-off loss and loss adjustment expense reserves |
| We completed the 2005 analysis during the three months ended September 30, 2005 |
| As a result of this analysis, we increased our loss and loss adjustment expense reserves by dlra0dtta2 million |
| Additionally, we increased our unallocated loss adjustment expense reserves by dlra4dtta1 million based on this analysis |
| We will continue to monitor industry trends and our own experience in order to determine the adequacy of our environmental and asbestos reserves |
| Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and could have a material adverse effect on our future financial condition, results of operations and cash flows |
| We have exposure to unpredictable catastrophes, which can materially and adversely affect our financial results |
| We are subject to claims arising out of catastrophes that may have a significant effect on our business, results of operations, and/or financial condition |
| Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hailstorms, explosions, power outages, severe winter weather, fires and by man-made events, such as terrorist attacks |
| The incidence and severity of catastrophes are inherently unpredictable |
| The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event |
| Insurance companies are not permitted to reserve for catastrophes until such event takes place |
| Therefore, although we actively manage our exposure to catastrophes through our underwriting process and the purchase of reinsurance protection, an especially severe catastrophe or series of catastrophes could exceed our reinsurance protection and may have a material adverse impact on our results of operations and/or financial condition |
| During the third and fourth quarters of 2005 and 2004, several hurricanes made landfall, one of which was one of the most devastating natural disasters in United States history |
| We have recorded our best estimate of the reserve for losses and loss adjustment expenses for these events as of December 31, 2005, and continue to evaluate our losses |
| For the 2005 hurricane activity, we recorded losses and loss adjustment expenses related to these hurricanes, net of reinsurance, of dlra12dtta0 million |
| As of December 31, 2004, we recorded losses and loss adjustment expenses related to the 2004 hurricane activity, net of reinsurance, of dlra17dtta7 million |
| During 2005, we recorded favorable development on the 2004 hurricanes of dlra3dtta0 million based on an actuarial review of our claims experience and expected ultimate losses |
| Additionally, reinstatement premiums related to our property catastrophe reinsurance program were dlra6dtta0 million and dlra1dtta8 million for the years ended December 31, 2005 and 2004, respectively |
| Due to the nature of the claims, there are significant uncertainties inherent in the loss estimation process |
| Due to these significant uncertainties, there can be no assurance that future adverse or favorable loss development will not occur |
| 19 ______________________________________________________________________ [63]Table of Contents [64]Index to Financial Statements We are currently attempting to exclude coverage for losses due to terrorist activity in our insurance policies where our underwriters determined that there was a significant risk of loss from terrorism activities and where permitted by state insurance departments |
| These policies include high profile locations, public entities and risks located in close proximity to potential terrorist targets |
| For a significant portion of the commercial insurance business offered by our insurance subsidiaries, excluding our workers’ compensation business, state insurance departments must approve the terms of our insurance forms and new exclusions included in those forms |
| Most states had approved terrorism exclusions for polices on commercial insurance business, other than workers’ compensation insurance |
| Terrorism exclusions are not permitted for workers’ compensation policies under the new federal act or under the laws of any state or jurisdiction in which we operate |
| When underwriting existing and new workers’ compensation business, we are considering the added potential risk of loss due to terrorist activity, and this may lead us to decline to write or to renew certain business |
| The federal act requires significant retention of terrorism losses by insurers based upon a percentage of earned premium for the prior year on a sliding scale from 7prca for 2003, 10prca for 2004, and 15prca for 2005 |
| Insurers also pay 10prca of losses over these retentions up to a maximum industry total of dlra100 billion |
| The federal act also does not apply to acts of domestic terrorism or acts that might otherwise be considered acts of terrorism that are not certified by the Secretary of the Treasury to be acts of terrorism under the federal act |
| We continue to attempt to exclude acts of terrorism not covered under the federal act, subject to state approvals |
| However, even when terrorism exclusions are permitted, because our clients may object to a terrorism exclusion in connection with business that we may still desire to write without an exclusion, some or many of our insurance policies may not include a terrorism exclusion |
| Given the retention limits imposed under the federal act and that some or many of our policies may not include an exclusion for terrorism, future terrorist attacks may result in losses that have a material adverse effect on our business, results of operations and/or financial condition |
| We face a risk of non-collectibility of reinsurance, which could materially and adversely affect our business, results of operations and/or financial condition |
| As is common practice within the insurance industry, we transfer a portion of the risks insured under our policies to other companies through purchasing reinsurance |
| This reinsurance is maintained to protect the insurance subsidiaries against the severity of losses on individual claims, unusually serious occurrences in which a number of claims produce an aggregate extraordinary loss and catastrophes |
| Although reinsurance does not discharge our subsidiaries from their primary obligation to pay for losses insured under the policies they issue, reinsurance does make the assuming reinsurer liable to the insurance subsidiaries for the reinsured portion of the risk |
| A credit exposure exists with respect to ceded losses to the extent that any reinsurer is unable or unwilling to meet the obligations assumed under the reinsurance contracts |
| The collectibility of reinsurance is subject to the solvency of the reinsurers, interpretation of contract language and other factors |
| We are selective in regard to our reinsurers, placing reinsurance with those reinsurers with strong financial strength ratings from A M Best, Standard and Poor’s, or a combination thereof, although the financial condition of a reinsurer may change based on market conditions |
| We perform credit reviews on our reinsurers, focusing on, among other things, financial condition, stability, trends and commitment to the reinsurance business |
| We also require assets in trust, letters of credit or other acceptable collateral to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions |
| It has not always been standard business practice to require security for balances due; therefore, certain balances are not collateralized |
| A reinsurer’s insolvency or inability to make payments under the terms of a reinsurance contract could have a material adverse effect on our results of operations and financial condition |
| We face a risk of non-availability of reinsurance, which could materially and adversely affect our ability to write business and our results of operations and financial condition |
| Market conditions beyond our control, such as the amount of capital in the reinsurance market and natural and man-made catastrophes, determine the availability and cost of the reinsurance protection we purchase |
| We cannot be assured that reinsurance will remain continuously available to the same extent and on the same terms and rates as are currently available |
| If we are unable to maintain our current level of reinsurance or purchase new reinsurance protection in amounts that are considered sufficient, we would either have to be willing to accept an increase in our net exposures or reduce our insurance writings |
| Since the events of September 11, 2001, reinsurers have generally included terrorism exclusions or limits in their reinsurance agreements |
| Although this has not materially affected the business written or our results of operations, future terrorist attacks could lead to claims under insurance policies that have been underwritten by us without terrorism exclusions, 20 ______________________________________________________________________ [65]Table of Contents [66]Index to Financial Statements which could have a material adverse effect on our results of operations and financial condition |
| Due to the hurricane activity in the third quarter of 2005, we believe that reinsurance rates will increase, but are unable to reasonably estimate the level of increase at this time |
| Because insurance ratings are important to our policyholders, downgrades in our insurance ratings may adversely affect our business |
| Rating agencies rate insurance companies based on financial strength and the ability to pay claims, factors more relevant to policyholders than investors |
| We believe that the ratings assigned by nationally recognized, independent rating agencies, particularly AM Best and Standard and Poor’s, are material to our operations |
| AM Best and Standard & Poor’s currently rate our principal insurance subsidiaries |
| Ratings are not recommendations to buy our securities |
| The rating scales of AM Best and S&P, are as follows: • AM Best—A++ to F (“Superior” to “In Liquidation”) • S&P—AAA to R (“Extremely Strong” to “Regulatory Supervision”) Our insurance subsidiaries are rated by AM Best |
| AM Best’s ratings are used by insurance buyers, agents and brokers and other insurance companies as an indicator of financial strength and security, and are not intended to reflect the quality of the rated company for investment purposes |
| The AM Best ratings of our insurance subsidiaries are as follows: Argonaut Insurance is rated as an “A” (Excellent) (3^rd highest rating out of 16 rating classifications) with a negative outlook; Colony and Rockwood are rated as an “A” (Excellent) with a stable outlook; and Great Central is rated as an “A-” (Excellent) (4^th highest rating out of 16 rating classifications) with a stable outlook |
| AM Best’s ratings are used by insureds, agents and brokers, and other insurance companies as an indicator of financial strength and security |
| Its ratings are not intended to reflect the quality of the rated company for investment purposes |
| AM Best reviews its ratings on a periodic basis, and ratings of our insurance subsidiaries are therefore subject to change |
| In November 2005, Standard & Poor’s upgraded its financial strength ratings to “A-” on our insurance subsidiaries, with a stable outlook |
| Standard & Poor’s also upgraded its counterparty credit rating on Argonaut Group, Inc |
| to “BBB-,” also with a stable outlook |
| A significant downgrade in these ratings could affect our competitive position in the insurance industry, make it more difficult for us to market our products and result in a material loss of business as policyholders move to other companies with higher claims-paying and financial strength ratings |
| These ratings are subject to revision or withdrawal at any time by the rating agencies, and therefore, no assurance can be given that our primary insurance subsidiaries can maintain these ratings |
| Each rating should be evaluated independently of any other rating |
| Because we are heavily regulated by the states in which we do business, we may be limited in the way in which we operate |
| The insurance industry is highly regulated and supervised |
| Our insurance subsidiaries are subject to the supervision and regulation of the states in which they are domiciled |
| Such supervision and regulation is designed to protect our policyholders rather than our stockholders |
| Such supervision and regulation includes matters relating to authorized lines of business, underwriting standards, financial condition standards, licensing of insurers, investment standards, premium levels, policy provisions, the filing of annual and other financial reports prepared on the basis of Statutory Accounting Principles, the filing and form of actuarial reports, dividends, and a variety of other financial and non-financial matters |
| Our insurance subsidiaries are participants of the statutorily created insolvency guarantee associations in all states where they are admitted licensed carriers |
| These associations were formed for the purpose of paying claims of insolvent companies |
| We are assessed our pro rata share of such claims based upon our premium writings, subject to a maximum annual assessment per line of insurance |
| Such costs can generally be recovered through surcharges on future premiums |
| We do not believe that assessments on current insolvencies will have a material effect on our financial condition or results of operations |
| Such regulation generally provides that 21 ______________________________________________________________________ [67]Table of Contents [68]Index to Financial Statements transactions between companies within the holding company system must be fair and equitable |
| Transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries and certain material transactions between companies within the system may be subject to prior notice to, or prior approval by, state regulatory authorities |
| Our insurance subsidiaries are subject to the risk-based capital, or RBC, provisions under the Insurers Model Act |
| RBC is designed to measure the acceptable amount of capital relative to the inherent specific risks of each insurer |
| RBC is calculated annually |
| State regulatory authorities use the RBC formula to identify insurance companies that may be undercapitalized and may require further regulatory attention |
| The formula prescribes a series of risk measurements to determine a minimum capital amount for an insurance company, based on the profile of the individual company |
| The ratio of a company’s actual policyholder surplus to its minimum capital requirements will determine whether any state regulatory action is required |
| The RBC for The Insurers Model Act provides four levels of regulatory activity if the RBC ratio yielded by the calculation falls below specified minimums |
| At each of four successively lower RBC ratios specified by statute, increasing regulatory remedies become available, some of which are mandatory |
| The four levels are: (1) Company Action Level Event, (2) Regulatory Action Level Event, (3) Authorized Control Level Event, and (4) Mandatory Control Level Event |
| As of December 31, 2005, all of our insurance subsidiaries had RBC ratios that exceed specified minimums |
| Because our investment portfolio is made up of fixed-income securities and equities, the fair value of our investment portfolio and our investment income could suffer as a result of fluctuations in interest rates and market conditions |
| Our market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of our investment portfolio as a result of fluctuations in prices and interest rates |
| In addition, our international business is subject to currency exchange rate risk |
| We have an exposure to foreign currency risks in conjunction with the reinsurance agreement with HCC Insurance Holdings Inc |
| and investments in foreign securities |
| Accounts under the International Directors and Officers Liability Quota Share program may settle in the following currencies: US dollars, British pounds, Canadian dollars or Euros |
| Remittances are due within 60 days of quarter end, one quarter in arrears |
| Due to the extended time frame for settling the accounts plus the fluctuation in currency exchange rates, the potential exists for us to realize gains and or losses related to the exchange rates |
| For the year ended December 31, 2005, we have recognized a foreign currency loss of dlra0dtta4 million related to this program |
| Management is unable at this time to estimate the future gains or losses, if any |
| We hold a diversified portfolio of investments in common stocks representing US firms in industries and market segments ranging from small market capitalization stocks to the Standard & Poor’s 500 stocks |
| The marketable equity securities are carried on the balance sheet at fair market value, and are subject to the risk of potential loss in market value resulting from adverse changes in prices |
| Equity price risk is managed primarily through the daily monitoring of funds committed to the various types of securities owned and by limiting the exposure in any one investment or type of investment |
| No issuer (exclusive of the US government and US governmental agencies) of fixed income or equity securities represents more than 10prca of shareholders’ equity as of December 31, 2005 |
| Our primary exposure to interest rate risk relates to our fixed maturity investments including redeemable preferred stock, as well as our junior subordinated debentures |
| Changes in market interest rates directly impact the market value of the fixed maturity securities, redeemable preferred stock and debt service requirements |
| Some fixed income securities have call or prepayment options |
| This subjects us to reinvestment risk if issuers call their securities and we reinvest the proceeds at lower interest rates |
| Litigation and legal proceedings against our insurance subsidiaries could have an adverse effect on our business, results of operations and/or financial condition |
| Our insurance subsidiaries have been sued in a number of class action lawsuits and other major litigation as a result of their insurance operations |
| Our insurance companies have responded to the lawsuits and believe that there are meritorious defenses and intend to vigorously contest these claims |
| The plaintiffs in certain of these lawsuits have not quantified the amounts they ultimately will seek to recover |
| In addition, in the case of class actions, it is uncertain whether a class will be certified, the number of persons included in any class, and the amount of damages that are ultimately sought by the class members |
| As a result, we are unable, with any degree of certainty, to determine a range of any potential loss, or whether such an outcome is probable or remote |
| However, adverse judgments in one or more of such lawsuits could have a material adverse effect on our financial results |
| 22 ______________________________________________________________________ [69]Table of Contents [70]Index to Financial Statements Our status as an insurance holding company could adversely affect our ability to meet our obligations and pay dividends |
| As an insurance holding company, we are largely dependent on dividends and other permitted payments from our insurance subsidiaries to pay any cash dividends to our stockholders, service debt and for our operating capital |
| The ability of our insurance subsidiaries to pay dividends to us is subject to certain restrictions imposed under California and Virginia insurance law, which are the states of domicile for Argonaut Insurance and Colony Insurance Company, our immediate insurance subsidiaries |
| During 2006, Argonaut Insurance may be permitted to pay dividends of up to dlra35dtta1 million in cash to Argonaut Group, Inc |
| without approval from the California Department of Insurance, while Colony may be permitted to pay dividends of up to dlra19dtta7 million in cash without approval from the Virginia Department of Insurance |
| Business and regulatory considerations may impact the amount of dividends actually paid, and prior approval of dividend payments may be required |