10-K 1 d449844d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                     to                     

Commission file number 1-9371

ALLEGHANY CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware   51-0283071

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

7 Times Square Tower,

New York, New York

  10036
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code:

212-752-1356

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange

on Which Registered

Common Stock, $1.00 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

Not applicable

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  þ                              No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes  ¨                            No  þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  þ                             No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.

Yes  þ                             No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  þAccelerated filer  ¨Non-accelerated filer  ¨Smaller reporting company  ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company.

Yes   ¨                             No   þ

The aggregate market value of voting and non-voting common shares held by non-affiliates of the registrant as of June 30, 2012 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $5,631,047,417 based on the closing sale price of the registrant’s common shares on the New York Stock Exchange on that date.

As of February 12, 2013, 16,804,007 shares of the registrant’s common stock, par value $1.00 per share, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement relating to the Annual Meeting of Stockholders of Alleghany Corporation to be held on April 26, 2013 to be filed with the Securities and Exchange Commission pursuant to Regulation 14A are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

 


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ALLEGHANY CORPORATION

Table of Contents

 

         Page  
 

PART I

  
Item 1.  

Business

     21   
Item 1A.  

Risk Factors

     38   
Item 1B.  

Unresolved Staff Comments

     48   
Item 2.  

Properties

     48   
Item 3.  

Legal Proceedings

     48   
Item 4.  

Mine Safety Disclosures

     49   
 

PART II

  
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      50   
Item 6.  

Selected Financial Data

     52   
Item 7.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     53   
Item 7A.  

Quantitative and Qualitative Disclosures about Market Risk

     90   
Item 8.  

Financial Statements and Supplementary Data

     93   
Item 9.  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     146   
Item 9A.  

Controls and Procedures

     146   
Item 9B.  

Other Information

     146   
 

PART III

  
Item 10.  

Directors, Executive Officers and Corporate Governance

     147   
Item 11.  

Executive Compensation

     147   
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      147   
Item 13.  

Certain Relationships and Related Transactions, and Director Independence

     148   
Item 14.  

Principal Accountant Fees and Services

     148   
 

PART IV

  
Item 15.  

Exhibits and Financial Statement Schedules

     149   

 

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ALLEGHANY CORPORATION

References in this Annual Report on Form 10-K for the year ended December 31, 2012, or this “Form 10-K,” to the “Company,” “Alleghany,” “we,” “us,” and “our” refer to Alleghany Corporation and its consolidated subsidiaries unless the context otherwise requires. In addition, unless the context otherwise requires, references to

 

   

“TransRe” are to our reinsurance holding company subsidiary Transatlantic Holdings, Inc. and its subsidiaries,

 

   

“TRC” are to our subsidiary Transatlantic Reinsurance Company and its subsidiaries,

 

   

“AIHL” are to our insurance holding company subsidiary Alleghany Insurance Holdings LLC,

 

   

“RSUI” are to our subsidiary RSUI Group, Inc. and its subsidiaries,

 

   

“CATA” are to our subsidiary Capitol Transamerica Corporation and its subsidiaries, and also include the operations and results of Platte River Insurance Company unless the context otherwise requires,

 

   

“PCC” are to our subsidiary Pacific Compensation Corporation and its subsidiaries,

 

   

“AIHL Re” are to our subsidiary AIHL Re LLC,

 

   

“Alleghany Capital Partners” are to our subsidiary Alleghany Capital Partners LLC,

 

   

“Alleghany Properties” are to our subsidiary Alleghany Properties Holdings LLC and its subsidiaries, and

 

   

“Bourn & Koch” are to our majority-owned subsidiary BKH Holdings, Inc. and its subsidiary Bourn & Koch, Inc., or “BKI.”

NOTE ON FORWARD-LOOKING STATEMENTS

This Form 10-K contains 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,

 

   

significant weather-related or other natural or man-made catastrophes and disasters;

 

   

the cyclical nature of the property and casualty reinsurance and insurance industries;

 

   

changes in market prices of our significant equity investments and changes in value of our debt securities portfolio;

 

   

adverse loss development for events insured by our reinsurance and insurance operating units in either the current year or prior years;

 

   

the long-tail and potentially volatile nature of certain casualty lines of business written by our reinsurance and insurance operating units;

 

   

the cost and availability of reinsurance;

 

   

exposure to terrorist acts and acts of war;

 

   

the willingness and ability of our reinsurance and insurance operating units’ reinsurers to pay reinsurance recoverables owed to our reinsurance and insurance operating units;

 

   

changes in the ratings assigned to our reinsurance and insurance operating units;

 

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claims development and the process of estimating reserves;

 

   

legal, political, judicial and regulatory changes, including the federal financial regulatory reform of the insurance industry by the Dodd-Frank Wall Street Reform and Consumer Protection Act or, the “Dodd-Frank Act”;

 

   

the uncertain nature of damage theories and loss amounts;

 

   

the reliance by our reinsurance operating units on a limited number of brokers;

 

   

increases in the levels of risk retention by our reinsurance and insurance operating units;

 

   

the loss of key personnel of our reinsurance or insurance operating units;

 

   

fluctuation in foreign currency exchange rates;

 

   

the failure to comply with the restrictive covenants contained in the agreements governing our indebtedness;

 

   

the ability to make payments on, or repay or refinance, our debt; and

 

   

risks inherent in international operations.

Additional risks and uncertainties include general economic and political conditions, including the effects of a prolonged U.S. or global economic downturn or recession; 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; 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. See Part I, Item 1A of this Form 10-K for a more detailed discussion of these risks and uncertainties.

 

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PART I

Item 1. Business.

Overview

We are a Delaware corporation which owns and manages operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance. We were incorporated in 1984 under the laws of the State of Delaware and in December 1986, we succeeded to the business of our parent company, Alleghany Corporation, which was incorporated in 1929.

Prior to March 6, 2012, Alleghany was primarily engaged, through AIHL and its subsidiaries, in the property and casualty insurance business. AIHL’s insurance operations are principally conducted by its subsidiaries RSUI, CATA and PCC. CATA has been a subsidiary of AIHL since January 2002, and RSUI has been a subsidiary of AIHL since July 2003. In June 2006, AIHL Re was established as a captive reinsurance subsidiary of AIHL, and AIHL Re has, in the past, provided reinsurance to our insurance operating units and affiliates. PCC has been a subsidiary of AIHL since July 18, 2007.

On March 6, 2012, or the “Acquisition Date,” pursuant to an Agreement and Plan of Merger, or the “Merger Agreement,” among Alleghany, our wholly-owned subsidiary, Shoreline Merger Sub, LLC (subsequently converted into a corporation), or “Merger Sub,” and Transatlantic Holdings, Inc., or “Old TransRe,” Old TransRe was merged with and into Merger Sub, or the “merger.” As a result of the merger, Merger Sub was renamed “Transatlantic Holdings, Inc.,” and Old TransRe became our wholly-owned subsidiary.

Pursuant to the terms of the Merger Agreement, on the Acquisition Date, former stockholders of Old TransRe were entitled to receive, in exchange for each share of Old TransRe common stock held, either shares of our common stock or cash consideration with a value equal to approximately $61.14. On the Acquisition Date, we paid to the former stockholders of Old TransRe total consideration of approximately $3.5 billion, consisting of cash consideration of $816.0 million and stock consideration of 8,360,959 shares of our common stock. Our reinsurance operations began immediately following the merger. See Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on the merger.

In addition to our reinsurance and insurance operations, we also own and manage a small group of non-reinsurance and insurance operating businesses and investments. As of December 31, 2012, Alleghany had total assets of $22.8 billion and total stockholders’ equity of $6.4 billion.

Our principal executive offices are located in leased office space at 7 Times Square Tower, New York, New York 10036, and our telephone number is (212) 752-1356. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the “Exchange Act,” are available, free of charge, on our website at www.alleghany.com, as soon as reasonably practicable after we electronically file this material with, or furnish it to, the U.S. Securities and Exchange Commission, or the “SEC.” Reports and other information we file with the SEC may also be viewed at the SEC’s website at www.sec.gov or viewed or obtained at the SEC Public Reference Room at 100 F Street, N.E., Washington, DC 20549. Our Financial Personnel Code of Ethics, Code of Business Conduct and Ethics, Corporate Governance Guidelines and the charters for our Audit, Compensation and Nominating and Governance Committees are also available on our website. In addition, interested parties may obtain, free of charge, copies of any of the above reports or documents upon request to the Secretary of Alleghany.

Segment Information

Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, Alleghany classifies its business into two reportable segments – reinsurance and insurance. Reinsurance and insurance underwriting activities are evaluated separately from investment and corporate activities. The primary components of “corporate activities” are Alleghany Properties, Alleghany’s investments in Homesite Group Incorporated, or “Homesite,” and ORX Exploration, Inc., or “ORX,” and strategic investments and other activities at the parent level. As of April 26, 2012, corporate activities also includes the operating results of BKI. See below and Note 13 to Notes to Consolidated Financial Statements set forth in Part

 

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II, Item 8 of this Form 10-K for an analysis of our underwriting results by segment and corporate activities, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Consolidated Results of Operations.”

Reinsurance Segment

General. The reinsurance segment consists of property and casualty reinsurance operations conducted by TransRe’s reinsurance operating units. TransRe, an international reinsurance organization, through its principal wholly-owned subsidiaries, Transatlantic Reinsurance Company, or “TRC,” TransRe Zurich Ltd., or “TRZ,” and Fair American Insurance and Reinsurance Company, or “FAIRCO,” offers reinsurance capacity to reinsurance and insurance companies for a full range of property and casualty products. These products are distributed through brokers and on a direct basis, in both the domestic and foreign markets. TransRe is headquartered in New York, New York, with six other locations in the United States and has operations worldwide, including in: Africa, Australia, Bermuda, Canada, three locations in Asia, three locations in Central and South America, and seven locations in the United Kingdom and Europe. One or both of TRC and FAIRCO are licensed, accredited or authorized or can serve as a reinsurer in the 50 states and the District of Columbia and in Puerto Rico and Guam. TRC is also licensed in Bermuda, Canada, Japan, the United Kingdom, the Dominican Republic, the Hong Kong Special Administrative Region of the People’s Republic of China, Germany and Australia. In addition, TRZ is licensed as a reinsurer in Switzerland.

The reinsurance segment is reported by two major product lines, “property” and “casualty & other.”

 

   

Property. TransRe’s principal lines of business within property include fire, allied lines, auto physical damage and homeowners multiple peril lines (which include property catastrophe risks). In 2012, property reinsurance accounted for approximately 32.9 percent of TransRe’s gross premiums written.

 

   

Casualty & Other. TransRe’s principal lines of business within casualty & other include liability (including directors’ and officers’, or “D&O,” liability, errors and omissions liability and general liability), medical malpractice, ocean marine and aviation, auto liability (including non-standard risks), accident and health, surety, and credit. In 2012, casualty reinsurance accounted for approximately 67.1 percent of TransRe’s gross premiums written.

TRC, TRZ and FAIRCO offer reinsurance capacity on both a treaty and facultative basis. Treaty reinsurance is a contractual arrangement that provides for the automatic reinsuring of a type or category of risk underwritten by the ceding company. Facultative reinsurance is the reinsurance of individual risks. Rather than agreeing to reinsure all or a portion of a class of risk, the reinsurer separately rates and underwrites each risk. Facultative reinsurance is normally purchased for risks not covered by treaty reinsurance or for individual risks covered by reinsurance treaties that are in need of capacity beyond that provided by such treaties.

A ceding company’s reinsurance program may involve pro rata and excess-of-loss reinsurance on both a treaty and facultative basis. TransRe provides pro rata and excess-of-loss reinsurance for most major lines of business. Under pro rata reinsurance (also referred to as proportional), the ceding company and the reinsurer share the premiums as well as the losses and expenses in an agreed proportion. As pro rata business is a proportional sharing of premiums and losses between ceding company and reinsurer, generally the underwriting reinsurance results of such business more closely reflect the underwriting results of the business ceded than do the results of excess-of-loss business. In pro rata reinsurance, the reinsurer generally pays the ceding company a ceding commission, which is generally based on the ceding company’s cost of obtaining the business being reinsured such as brokers’ and agents’ commissions, local taxes and administrative expenses. Under excess-of-loss reinsurance, the reinsurer agrees to reimburse the ceding company for all losses in excess of a predetermined amount up to a predetermined limit. Premiums paid by the ceding company to the reinsurer for excess-of-loss coverage are generally not proportional to the premiums that the ceding company receives because the reinsurer does not assume a proportionate risk. Often there is no ceding commission on excess-of-loss reinsurance and therefore the pricing mechanism used by reinsurers in those instances is a rate applicable to premiums of the individual policy or policies subject to the reinsurance agreement.

As of December 31, 2012, the statutory surplus of TRC was $4.2 billion, including the statutory surplus of FAIRCO of $271.4 million.

 

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Distribution. TransRe provides property and casualty reinsurance capacity through brokers as well as directly to insurance and reinsurance companies in both the domestic and international markets. In 2012, approximately 82 percent of TransRe’s gross premiums written were written through brokers with the balance written directly. In 2012, companies controlled by Aon Corporation, Marsh & McLennan Companies, Inc. and Willis Group Holdings, plc, were TransRe’s largest brokerage sources of business, accounting for 26 percent, 21 percent and 12 percent, respectively, of gross premiums written. These three international brokers dominate the reinsurance brokerage industry. Due to the substantial percentages of premiums written through these brokers, the loss of business from any one of them could have a material adverse effect on TransRe’s business.

Underwriting. TransRe’s underwriting process emphasizes a team approach among TransRe’s underwriters, actuaries and claims staff, as appropriate. Treaties are reviewed for compliance with TransRe’s underwriting guidelines and objectives, and most treaties are evaluated in part based upon actuarial analyses conducted by TransRe. TransRe’s actuarial models used in such analyses are tailored in each case to the exposures and experience underlying the specific treaty and the loss experience for the risks covered. Property catastrophe exposed treaties are generally evaluated using industry standard models. These models are used as a guide for risk assessment and are continually being updated. TransRe also frequently conducts underwriting and claims audits at the offices of a prospective ceding company before and after entering into major treaties, because reinsurers, including TransRe, do not separately evaluate each of the individual risks assumed under their treaties and, consequently, are largely dependent on the original underwriting decisions made by the ceding company. Such dependence subjects TransRe, and reinsurers in general, to the possibility that the ceding companies have not adequately evaluated the risks to be reinsured and, therefore, that the premiums ceded in connection therewith may not adequately compensate the reinsurer for the risk assumed.

TransRe often seeks to lead treaty arrangements. The lead reinsurer on a treaty generally accepts one of the largest percentage shares of the treaty and takes the initiative in negotiating price, terms and conditions. TransRe believes that this strategy has enabled it to influence more effectively the terms and conditions of the treaties in which it has participated. When TransRe does not lead a treaty, it may still suggest changes to any aspect of the treaty. TransRe may reject any treaty business offered to it based upon its assessment of all relevant factors. Such factors include type and level of risk assumed; actuarial and underwriting judgment with respect to rate adequacy; various treaty terms; prior and anticipated loss experience (including exposure to natural and man-made catastrophes) on the treaty; prior business experience with the ceding company; overall financial position; operating results; ratings from credit rating agencies of the ceding company; and social, legal, regulatory, environmental and general economic conditions affecting the risks assumed or the ceding company.

Ratings. TRC, TRZ and FAIRCO are rated “A+” by Standard & Poor’s Ratings Services, or “S&P,” and “A” (Excellent) by A.M. Best Company, Inc., or “A.M. Best,” and TRC is rated “A1” by Moody’s Investors Service Inc., or “Moody’s,” independent organizations that analyze the insurance industry and the financial positions of reinsurance and insurance companies. Additional information regarding ratings and the risks related to ratings from ratings agencies can be found on pages 42 and 43 of this Form 10-K.

Insurance Segment

The insurance segment consists of property and casualty insurance operations conducted by AIHL through its insurance operating units RSUI, headquartered in Atlanta, Georgia; CATA, headquartered in Middleton, Wisconsin; and PCC, headquartered in Agoura Hills, California. AIHL Re, our Vermont-domiciled captive reinsurance company, has, in the past, provided reinsurance to our insurance operating units and affiliates. Unless we state otherwise, references to AIHL include the operations of RSUI, CATA, PCC and AIHL Re.

In 2012, property insurance accounted for approximately 49 percent, and casualty insurance accounted for approximately 51 percent, of AIHL’s gross premiums written.

RSUI

General. RSUI, which includes the operations of its wholly-owned subsidiaries RSUI Indemnity Company, or “RIC,” Landmark American Insurance Company, or “Landmark,” and Covington Specialty Insurance Company, or “Covington,” underwrites specialty insurance coverages in the property, umbrella/excess liability,

 

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general liability, D&O liability and professional liability lines of business. RSUI also writes a modest amount of reinsurance business on an assumed basis, which is included in the insurance segment.

The market for specialty insurance coverages differs significantly from the market for standard insurance coverages. The specialty market provides coverage for hard-to-place risks that generally do not fit the underwriting criteria of the standard market which provides coverage for largely uniform and relatively predictable exposures and which is highly regulated with respect to rates and forms.

RSUI writes specialty business on both an admitted and non-admitted basis. Insurers may market, sell and service insurance policies in the states where they are licensed. These insurers are referred to as admitted insurers. Admitted insurers are generally required to obtain regulatory approval of their policy forms and premium rates. Non-admitted insurance markets have developed to provide insurance that is otherwise unavailable from the admitted insurance markets of a state. Non-admitted insurance is procured by either state-licensed surplus lines brokers who place risks with insurers not licensed in that state or by insureds’ direct procurement from non-admitted insurers. Non-admitted insurance is subject to considerably less regulation with respect to policy rates and forms.

RSUI writes specialty business in the admitted specialty market primarily through RIC in the 50 states and the District of Columbia where RIC is licensed and subject to state form and rate regulations. Most of the risks in the admitted specialty market are unique and hard-to-place in the standard market, but must remain with an admitted insurance company for regulatory and/or marketing reasons. As an admitted carrier, RIC is subject to more state regulation than a non-admitted carrier, particularly with regard to rate and form filing requirements, restrictions on the ability to exit lines of business, premium tax payments and membership in various state associations, such as state guaranty funds and assigned risk plans.

RSUI writes business on an approved, non-admitted basis primarily through Landmark, which, as a non-admitted company, is not subject to state form and rate regulations and thus has more flexibility in its rates and coverages for specialized or hard-to-place risks. This typically results in coverages that are more restrictive and expensive than coverages written by a standard insurance company. As of December 31, 2012, Landmark was approved to write business on a non-admitted basis in 49 states and is a domestic surplus lines company in Oklahoma.

Covington, a New Hampshire-domiciled insurer, was formed in September 2007 to, among other things, support non-admitted business written primarily by RSUI’s binding authority department, which writes small, specialized coverages pursuant to underwriting authority arrangements with managing general agents.

Pursuant to quota share arrangements effective as of January 1, 2009, Landmark and Covington cede 90 percent of all their respective premiums and losses, gross of third party reinsurance, to RIC.

As of December 31, 2012, the statutory surplus of RIC was approximately $1.3 billion, the statutory surplus of Landmark was $191.6 million, and the statutory surplus of Covington was $46.6 million.

Distribution. As of December 31, 2012, RSUI conducted its insurance business through approximately 146 independent wholesale insurance brokers located throughout the United States and 31 managing general agents. RSUI’s wholesale brokers are appointed on an individual basis based on management’s appraisal of expertise and experience, and only specific locations of a wholesale broker’s operations may be appointed to distribute RSUI’s products. Producer agreements which stipulate premium collection, payment terms and commission arrangements are in place with each wholesale broker. No wholesale broker holds underwriting, claims or reinsurance authority. RSUI has entered into underwriting authority arrangements with 31 managing general agents for small, specialized coverages. RSUI’s top five producing wholesale brokers accounted for approximately 60 percent of gross premiums written by RSUI in 2012. RSUI’s top two producing wholesale brokers, Swett & Crawford Group and AmWINS Group, Inc. accounted for, in the aggregate, approximately 33.7 percent of AIHL’s gross premiums written in 2012.

Underwriting. RSUI’s underwriting philosophy is based on handling only product lines in which its underwriters have underwriting expertise. RSUI generally focuses on higher severity, lower frequency specialty

 

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risks that can be effectively “desk underwritten” without the need for inspection or engineering reviews. RSUI tracks underwriting results for each of its underwriters and believes that the underwriting systems and applications it has in place facilitate efficient underwriting and high productivity levels. Underwriting authority is delegated on a “top-down” basis ultimately to individual underwriters based on experience and expertise. This authority is in writing and addresses maximum limits, excluded classes and coverages and premium size referral. Referral to a product line manager is required for risks exceeding an underwriter’s authority.

Ratings. RIC is rated “A” (Excellent) by A.M. Best. Landmark and Covington are rated “A” (Excellent) on a reinsured basis by A.M. Best.

CATA

General. CATA, primarily through its wholly-owned subsidiaries Capitol Indemnity Corporation, or “Capitol Indemnity,” and Capitol Specialty Insurance Corporation, or “CSIC,” operates in the 50 states and the District of Columbia. CATA also includes the operations and results of Platte River Insurance Company, or “Platte River.”

Capitol Indemnity conducts its property and casualty insurance business on an admitted basis, with a geographic concentration in the Midwestern and Plains states. Capitol Indemnity also writes surety products such as commercial surety bonds and contract surety bonds on a national basis. Commercial surety bonds include all surety bonds other than contract surety bonds and cover obligations typically required by law or regulation, such as licenses and permits. Capitol Indemnity offers contract surety bonds in the non-construction segment of the market which secure performance under supply, service and maintenance contracts. Capitol Indemnity also offers developer subdivision bonds in the construction segment of the market which secure performance and payment obligations under federal, state, local and private construction contracts.

CSIC conducts substantially all of its business on an approved, non-admitted basis on a national basis and writes primarily specialty lines of property and casualty insurance.

Platte River is licensed in the 50 states and the District of Columbia and operates in conjunction with Capitol Indemnity primarily by providing surety products and offering pricing flexibility in those jurisdictions where both Capitol Indemnity and Platte River are licensed.

In 2012, the property and casualty business accounted for approximately 67.2 percent of CATA’s gross premiums written (including approximately 5.5 percent of professional liability), and the surety business accounted for the remainder.

As of December 31, 2012, the statutory surplus of Capitol Indemnity was $162.5 million, including the statutory surplus of CSIC of $52.2 million. As of December 31, 2012, the statutory surplus of Platte River was $37.7 million.

Distribution. CATA conducts its insurance business through independent and general insurance agents located throughout the United States. As of December 31, 2012, CATA had approximately 316 independent agents and 59 general agents licensed to write property and casualty and surety coverages, approximately 91 agents specializing in professional liability coverages and approximately 283 independent agents licensed only to write surety coverages. The general agents write very little surety business and have full quoting and binding authority within the parameters of their agency contracts with respect to the property and casualty business that they write. Certain independent agents have binding authority for specific business owner policy products, including property and liability coverages and non-contract surety products. No agent of CATA had writings in excess of 11 percent of CATA’s gross premiums written in 2012.

Underwriting. Elements of CATA’s underwriting process include prudent risk selection, appropriate pricing and coverage customization. All accounts are reviewed on an individual basis to determine underwriting acceptability. CATA is a subscriber to the Insurance Service Organization, or “ISO,” and the Surety and Fidelity Association of America, or “SFAA,” insurance reference resources recognized by the insurance industry. CATA’s underwriting procedures, rates and contractual coverage obligations are based on procedures and data developed by the ISO for property and casualty lines and by the SFAA for surety lines. Underwriting

 

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acceptability is determined by type of business, claims experience, length of time in business and business experience, age and condition of premises occupied and financial stability. Information is obtained from, among other sources, agent applications, financial reports and on-site loss control surveys. If an account does not meet pre-determined acceptability parameters, coverage is declined. If an in-force policy becomes unprofitable due to extraordinary claims activity or inadequate premium levels, a non-renewal notice is issued in accordance with individual state statutes and rules.

Ratings. Capitol Indemnity, CSIC and Platte River are rated “A” (Excellent) on a reinsured basis by A.M. Best.

PCC

General. Prior to June 2009, PCC’s main business was workers’ compensation insurance, which was conducted on a direct basis through its wholly-owned subsidiary Pacific Compensation Insurance Company, or “PCIC.” In June 2009, PCC determined that it was unable to write business at rates it deemed adequate due to the state of the California workers’ compensation market. As a result, PCC ceased soliciting new or renewal business on a direct basis commencing August 1, 2009 and took corresponding expense reduction steps, including staff reductions. During the 2009 third quarter, PCC sold the renewal rights of its directly placed workers’ compensation insurance policies and certain other assets and rights to an independent insurance brokerage.

As part of a strategic repositioning effort, effective April 12, 2010, PCC changed its name from Employers Direct Corporation and changed the name of its wholly-owned insurance subsidiary from Employers Direct Insurance Company to PCIC and took steps to emerge as a writer, through PCIC, of workers’ compensation insurance distributed through independent insurance brokers. During 2011 and 2012, PCC began writing a modest amount of new business, all of which was through brokers.

PCIC is currently licensed in California and seven additional states. As of December 31, 2012, the statutory surplus of PCIC was $108.9 million.

Rating. As a result of PCC’s determination to cease writing business on a direct basis and certain other factors, on June 30, 2009, A.M. Best downgraded its rating of PCIC to “B++” (Good), with a stable outlook, from “A-” (Excellent), with a negative outlook.

Reserves

Each of our reinsurance and insurance operating units establishes reserves on its balance sheet for unpaid loss and loss adjustment expense, or “LAE,” related to its property and casualty reinsurance and insurance contracts. The reserves for loss and LAE represent management’s best estimate of the ultimate cost of all reported and unreported losses incurred through the balance sheet date. The estimation of loss reserves is inherently difficult and subjective, especially in view of changing legal and economic environments that impact the development of loss reserves. Therefore, quantitative techniques have to be supplemented by subjective considerations and managerial judgment. In addition, conditions and trends that have affected development of liabilities in the past may not necessarily occur or affect liability development to the same degree in the future. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates.”

Changes in Historical Net Loss and LAE Reserves

The following table shows changes in historical net loss and LAE reserves for our reinsurance and insurance operating units for each year since 2002.

The first line of the upper portion of the table shows the net reserves as of December 31 of each of the indicated years, representing the estimated amounts of net outstanding loss and LAE for claims arising during that year and in all prior years that are unpaid, including losses that have been incurred but not yet reported, or

 

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“IBNR,” to our reinsurance and insurance operating units. The upper (paid) portion of the table shows the cumulative net amounts paid as of December 31 of successive years with respect to the net reserve liability for each year.

The lower portion of the table shows the re-estimated amount of the previously recorded net reserves for each year based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about claims for individual years. In evaluating the information in the table, it should be noted that a reserve amount reported in any period includes the effect of any subsequent change in such reserve amount. For example, if a loss was first reserved in 2003 at $100,000 and was determined in 2012 to be $150,000, the $50,000 deficiency would be included in the Cumulative (Deficiency) Redundancy row shown below for each of the years 2003 through 2011.

Changes in Historical Net Reserves for Loss and LAE

 

    Years Ended December 31,  
    2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012  
    (in millions)  

Net liability as of end of year

  $ 113.3      $ 276.0      $ 639.0      $ 952.9      $ 1,127.5      $ 1,412.9      $ 1,570.3      $ 1,573.3      $ 1,481.3      $ 1,481.2      $ 10,933.9   

Cumulative amount of net liability paid as of:

                     

One year later

    47.4        72.6        239.4        172.7        243.3        296.1        355.6        388.7        345.7        369.5     

Two years later

    80.6        116.8        310.8        356.1        421.7        515.0        659.5        642.2        616.4       

Three years later

    100.1        149.6        365.2        493.2        529.6        708.5        848.9        841.9         

Four years later

    110.1        173.7        413.6        572.2        648.6        820.6        990.1           

Five years later

    115.8        191.7        446.9        664.7        697.9        909.2             

Six years later

    121.7        208.0        465.4        703.0        732.3               

Seven years later

    124.0        220.0        475.0        725.8                 

Eight years later

    125.5        224.1        486.5                   

Nine years later

    126.6        229.8                     

Ten years later

    128.7                       

Net liability re-estimated as of:

                     

One year later

    134.0        268.7        631.8        943.2        1,115.4        1,370.0        1,552.4        1,539.6        1,455.5        1,468.9     

Two years later

    147.7        264.6        620.1        941.2        1,047.9        1,341.9        1,526.5        1,506.7        1,457.2       

Three years later

    149.0        268.1        593.3        899.7        1,012.5        1,306.7        1,486.0        1,497.8         

Four years later

    150.7        263.8        584.1        873.0        976.7        1,263.2        1,465.4           

Five years later

    153.5        262.0        566.7        858.8        933.0        1,241.9             

Six years later

    151.7        256.1        554.0        832.7        919.2               

Seven years later

    148.4        252.8        537.6        826.7                 

Eight years later

    143.6        250.1        539.5                   

Nine years later

    142.3        254.2                     

Ten years later

    144.3                       

Cumulative (deficiency) redundancy

  $ (31.0   $ 21.8      $ 99.5      $ 126.2      $ 208.3      $ 171.0      $ 104.9      $ 75.5      $ 24.1      $ 12.3      $ —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross liability-end of year

  $ 258.0      $ 438.0      $ 1,246.4      $ 2,571.9      $ 2,228.9      $ 2,379.7      $ 2,578.6      $ 2,521.0      $ 2,328.7      $ 2,313.0      $ 12,239.8   

Less: reinsurance recoverable

    144.7        162.0        607.4        1,619.0        1,101.4        966.8        1,008.3        947.7        847.4        831.8        1,305.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net liability-end of year

  $ 113.3      $ 276.0      $ 639.0      $ 952.9      $ 1,127.5      $ 1,412.9      $ 1,570.3      $ 1,573.3      $ 1,481.3      $ 1,481.2      $ 10,933.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross re-estimated liability-latest

  $ 277.5      $ 430.0      $ 1,096.1      $ 2,259.8      $ 1,769.1      $ 1,963.1      $ 2,247.6      $ 2,279.6      $ 2,226.6      $ 2,280.9      $ 12,239.8   

Re-estimated recoverable- latest

    133.2        175.8        556.6        1,433.1        849.9        721.2        782.2        781.8        769.4        812.0        1,305.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net re-estimated liability-latest

  $ 144.3      $ 254.2      $ 539.5      $ 826.7      $ 919.2      $ 1,241.9      $ 1,465.4      $ 1,497.8      $ 1,457.2      $ 1,468.9      $ 10,933.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross cumulative (deficiency) redundancy

  $ (19.5   $ 8.0      $ 150.3      $ 312.1      $ 459.8      $ 416.6      $ 331.0      $ 241.4      $ 102.1      $ 32.1      $ —     

 

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The net cumulative redundancies since 2003 primarily reflect casualty net reserve releases by RSUI, partially offset by catastrophe-related net reserve increases by RSUI in 2006 and 2007, as well as reserve increases at PCC in each year from 2008 through 2012, respectively. In addition, CATA recorded reserve increases in 2011 and 2012 related to a discontinued line of business. Prior year reserve adjustments are discussed on pages 73 and 74 of this Form 10-K.

The reconciliation between the aggregate net loss and LAE reserves of our reinsurance and insurance operating units reported in the annual statements filed with state insurance departments prepared in accordance with statutory accounting principles, or “SAP,” and those reported in our consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States, or “GAAP,” for the last three years is shown below (in millions):

Reconciliation of Reserves for Loss and LAE from SAP Basis to GAAP Basis

 

     2012     2011     2010  

Stautory reserves

   $ 10,475.2      $ 1,481.8      $ 1,482.3   

Net reserves of non-U.S. subsidiaries(1)

     459.1                 

Reinsurance recoverables(2)

     1,305.9        831.8        847.4   

Purchase accounting adjustment

     (0.4     (0.6     (1.0
  

 

 

   

 

 

   

 

 

 

GAAP reserves

   $ 12,239.8      $ 2,313.0      $ 2,328.7   
  

 

 

   

 

 

   

 

 

 

 

(1) TransRe’s non-U.S. subsidiaries do not file annual statements with state insurance departments in the United States.

 

(2) Reinsurance recoverables in this table include only unpaid ceded loss reserves. Amounts reflected under the caption “Reinsurance recoverables” on our consolidated balance sheets set forth in Part II, Item 8 of this Form 10-K also include paid loss recoverables.

The reconciliation of beginning and ending aggregate reserves for unpaid loss and LAE of our reinsurance and insurance operating units for the last three years is shown below (in millions):

Reconciliation of Reserves for Loss and LAE

 

     Years Ended December 31,  
     2012     2011     2010  

Reserves as of January 1

   $ 2,313.0      $ 2,328.7      $ 2,521.0   

Less: reinsurance recoverables(1)

     831.8        847.4        947.7   
  

 

 

   

 

 

   

 

 

 

Net reserves

     1,481.2        1,481.3        1,573.3   
  

 

 

   

 

 

   

 

 

 

Reserves acquired(2)

     9,156.1                 
  

 

 

   

 

 

   

 

 

 

Incurred loss, net of reinsurance, related to:

      

Current year(3)

     2,642.6        455.8        411.6   

Prior years

     (12.3     (25.8     (33.7
  

 

 

   

 

 

   

 

 

 

Total incurred loss and LAE, net of reinsurance

     2,630.3        430.0        377.9   
  

 

 

   

 

 

   

 

 

 

Paid loss, net of reinsurance, related to:

      

Current year(3)

     1,950.5        84.4        81.2   

Prior years

     369.5        345.7        388.7   
  

 

 

   

 

 

   

 

 

 

Total paid loss and LAE, net of reinsurance

     2,320.0        430.1        469.9   
  

 

 

   

 

 

   

 

 

 

Foreign exchange effect(3)

     (13.7              
  

 

 

   

 

 

   

 

 

 

Reserves, net of reinsurance recoverables, as of December 31

     10,933.9        1,481.2        1,481.3   

Reinsurance recoverables as of December 31(1)

     1,305.9        831.8        847.4   
  

 

 

   

 

 

   

 

 

 

Reserves, gross of reinsurance recoverables, as of December 31

   $ 12,239.8      $ 2,313.0      $ 2,328.7   
  

 

 

   

 

 

   

 

 

 

 

(1) Reinsurance recoverables in this table include only unpaid ceded loss reserves. Amounts reflected under the caption “Reinsurance recoverables” on our consolidated balance sheets set forth in Part II, Item 8 of this Form 10-K also include paid loss recoverables.

 

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(2) Represents the carrying value of TransRe’s net reserves acquired in the merger. As of the Acquisition Date, gross loss reserves were $9,627.8 million and ceded loss reserves were $471.7 million.

 

(3) Includes amounts for TransRe from the Acquisition Date through December 31, 2012, including $87.8 million of favorable development from prior accident years on loss and LAE reserves acquired.

Asbestos and Environmental Impairment Reserves

Our reinsurance and insurance operating units’ reserves for loss and LAE include amounts for risks relating to asbestos-related illnesses and environmental impairment. The reserves carried for such claims, including the IBNR portion, are based upon known facts and current legal environment at the balance sheet date. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illnesses and environmental impairment losses, particularly for those occurring in 1985 and prior, which represent the majority of TransRe’s asbestos-related illnesses and environmental impairment reserves. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings. Although we are unable at this time to determine whether additional reserves, which could have a material adverse effect upon our results of operations, may be necessary in the future, we believe that our asbestos-related illnesses and environmental impairment reserves are adequate as of December 31, 2012.

As of December 31, 2012 and 2011, gross and net loss and LAE reserves for risks relating to asbestos-related illnesses and environmental impairment were as follows (in millions):

 

     December 31, 2012      December 31, 2011  
     Gross      Net      Gross      Net  

TransRe

   $ 512.4       $ 394.5       $       $   

CATA

     13.5         13.5         13.7         13.7   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 525.9       $ 408.0       $ 13.7       $ 13.7   
  

 

 

    

 

 

    

 

 

    

 

 

 

As of December 31, 2012, the reserves for asbestos liabilities were approximately 11 times the average paid claims for the prior three year period, compared with 23 times as of December 31, 2011. The reserves for environmental impairment liabilities were approximately 9 times the average paid claims for the prior three year period, compared with five times as of December 31, 2011. The significant changes in these metrics from December 31, 2011 to December 31, 2012 reflect the impact of TransRe’s asbestos and environmental reserves.

The reconciliation of the beginning and ending gross reserves for unpaid loss and LAE related to asbestos and environmental impairment claims of our reinsurance and insurance operating units for the years 2010 through 2012 is shown below (in millions):

Reconciliation of Asbestos-Related Claims Reserves for Loss and LAE

 

     2012     2011     2010  

Reserves as of January 1

   $ 11.0      $ 11.3      $ 15.1   

Reserves acquired(1)

     340.0                 

Loss and LAE incurred

     40.8               (3.0

Paid losses(2)

     (20.5     (0.3     (0.8
  

 

 

   

 

 

   

 

 

 

Reserves as of December 31

   $ 371.3      $ 11.0      $ 11.3   
  

 

 

   

 

 

   

 

 

 

Type of reserves

      

Case

   $ 148.6      $ 1.6      $ 1.7   

IBNR

     222.7        9.4        9.6   
  

 

 

   

 

 

   

 

 

 

Total

   $ 371.3      $ 11.0      $ 11.3   
  

 

 

   

 

 

   

 

 

 

 

(1) Represents the carrying value of TransRe’s reserves acquired in the merger.

 

(2) Paid losses include commutations and legal settlements as well as regular paid losses.

 

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Reconciliation of Environmental Impairment Claims Reserves for Loss and LAE

 

     2012     2011     2010  

Reserves as of January 1

   $ 2.7      $ 2.8      $ 3.8   

Reserves acquired(1)

     150.1                 

Loss and LAE incurred

     15.4               (0.5

Paid losses(2)

     (13.6     (0.1     (0.5
  

 

 

   

 

 

   

 

 

 

Reserves as of December 31

   $ 154.6      $ 2.7      $ 2.8   
  

 

 

   

 

 

   

 

 

 

Type of reserves

      

Case

   $ 37.0      $ 0.4      $ 0.4   

IBNR

     117.6        2.3        2.4   
  

 

 

   

 

 

   

 

 

 

Total

   $ 154.6      $ 2.7      $ 2.8   
  

 

 

   

 

 

   

 

 

 

 

(1) Represents the carrying value of TransRe’s reserves acquired in the merger.

 

(2) Paid losses include commutations and legal settlements as well as regular paid losses.

Catastrophe Risk Management

The business of our reinsurance and insurance operating units exposes them to losses from various catastrophe events. In a catastrophe event, losses from many insureds across multiple lines of business may result directly or indirectly from such single occurrence. Our reinsurance and insurance operating units take certain measures to mitigate the impact of catastrophe events through various means including considering catastrophe risks in their underwriting and pricing decisions, purchasing reinsurance, monitoring and modeling accumulated exposures, and managing exposure in key geographic zones and product lines that are prone to catastrophe events.

Natural disasters such as hurricanes, other windstorms, earthquakes and other catastrophes have the potential to materially and adversely affect our operating results. Other risks, such as an outbreak of a pandemic disease, a major terrorist event, the bankruptcy of a major company, or a marine or an aviation disaster, could also have a material adverse effect on our business and operating results.

We evaluate catastrophic events and assess the probability of occurrence and magnitude through the use of industry recognized models and other techniques. We supplement these models by judgmentally interpreting and adjusting when appropriate the modeled output and by monitoring the exposure risks of our operations. There is no single standard methodology to project possible losses from catastrophe exposures. Further, there are no industry standard assumptions used in projecting these losses, and the form and quality of the data obtained, including data obtained from insureds and ceding companies, and used in these models are not uniformly compatible with the data requirements of all models. Therefore, the use of different methodologies and assumptions could materially change the projected losses. Finally, these modeled losses may not be comparable with estimates made by other companies.

Our reinsurance and insurance operating units use modeled loss scenarios to set risk retention levels and help structure their reinsurance programs in an effort to ensure that the aggregate amount of catastrophe exposures conform to established risk tolerances and fit within the existing exposure portfolio. Our reinsurance and insurance operating units also use reinsurance to limit their exposure to catastrophes, as is discussed in more detail under “Reinsurance” below. Additional information regarding the risks faced by our reinsurance and insurance operating units with respect to managing their catastrophe exposure risk can be found on pages 41 and 42 and page 89 of this Form 10-K.

With respect to terrorism, to the extent that reinsurers have excluded coverage for terrorist acts or have priced this coverage at rates that make purchasing such coverage uneconomic, our reinsurance and insurance operating units will not have reinsurance protection and are exposed to potential losses as a result of acts of terrorism. To the extent an act of terrorism is certified by the U.S. Secretary of the Treasury, we may be covered under the Terrorism Act (as defined on page 31 of this Form 10-K).

 

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Reinsurance

Our reinsurance and insurance operating units reinsure portions of the risks they underwrite or assume in order to mitigate exposures to losses, manage capacity and protect capital resources. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance operating units would remain liable for amounts not paid by these reinsurers. As such, funds, trust agreements and letters of credit are held to collateralize a portion of our reinsurance recoverables and our reinsurance and insurance operating units reinsure portions of the risks they underwrite or assume with multiple reinsurance programs.

RSUI reinsures its property lines of business through a program consisting of facultative placements and surplus share, per risk, and catastrophe excess of loss treaties. RSUI’s catastrophe reinsurance program (which covers catastrophe risks including, among others, windstorms and earthquakes) and per risk treaty run on an annual basis from May 1 to the following April 30 and thus will expire on April 30, 2013.

On May 1, 2012, RSUI placed its catastrophe reinsurance program for the 2012-2013 period. The catastrophe reinsurance program provides coverage in three layers for $500.0 million of losses in excess of a $100.0 million net retention after application of the surplus share treaties, facultative reinsurance and per risk covers. The first layer provides coverage for $100.0 million of losses, before a 60.0 percent co-participation by RSUI, in excess of the $100.0 million net retention. The second layer provides coverage for $300.0 million of losses, before a 5.0 percent co-participation by RSUI, in excess of $200.0 million. The third layer provides coverage for $100.0 million of losses in excess of $500.0 million, with no co-participation by RSUI. In addition, RSUI’s property per risk reinsurance program for the 2012-2013 period provides RSUI with coverage for $90.0 million of losses, before a 10.0 percent co-participation by RSUI, in excess of a $10.0 million net retention per risk after application of the surplus share treaties and facultative reinsurance.

To a limited extent, TransRe enters into retrocession arrangements, including property catastrophe retrocession arrangements, in order to reduce the effect of individual or aggregate losses, to reduce volatility in specific lines of business, to improve risk adjusted portfolio returns and to increase gross premium writings and risk capacity without requiring additional capital. As of December 31, 2012, no reinsurance recoverable from a single reinsurer was considered material to the financial position of TransRe.

With respect to potential losses at RSUI arising from acts of terrorism, the Terrorism Risk Insurance Act of 2002, as extended and amended by the Terrorism Risk Insurance Extension Act of 2005 and the Terrorism Risk Insurance Program Reauthorization Act of 2007, which we collectively refer to as the “Terrorism Act,” established a program to provide federal assistance to the insurance industry in order to meet the needs of commercial insurance policyholders for coverages against losses due to certain acts of terrorism. The Terrorism Act is administered by the U.S. Secretary of the Treasury and is effective through December 31, 2014, at which time it will automatically expire unless reauthorized by the U.S. Congress. Legislation is currently pending in the U.S. House of Representatives that would extend the Terrorism Act through 2019. Although this legislation is pending, it is uncertain whether it will ultimately be enacted, and we will continue to monitor the impact such legislation may have on our reinsurance and insurance operating units.

The Terrorism Act applies to foreign or domestic acts of terrorism occurring within the United States (including in the U.S. territorial sea and the Outer Continental Shelf), at U.S. missions abroad, or on U.S. flag vessels or aircraft. In return for requiring insurers writing certain lines of property and casualty insurance to offer coverage to commercial insurance policyholders against certain acts of terrorism, the law requires the U.S. Federal government to reimburse such insurers for 85 percent of insured losses during a program year resulting from such acts of terrorism above a statutorily-defined deductible. AIHL’s deductible under the Terrorism Act in 2013 will be 20 percent of its direct premiums earned in eligible lines in 2012, or $150.5 million. In addition, federal reimbursement will only be paid under the Terrorism Act if the aggregate industry insured losses resulting from the covered act of terrorism exceed $100.0 million for insured losses occurring in 2013, but no payment will be made for any portion of aggregate industry insured losses that exceeds $100.0 billion in 2013.

The coverage provided by the Terrorism Act does not apply to reinsurers. In general, TransRe does not provide cover for certified acts of terrorism, as defined by the Terrorism Act, but it is exposed to potential losses

 

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from uncertified acts of terrorism in the U.S. or elsewhere. In addition, TransRe offers terrorism-specific treaty coverages to ceding companies on a limited basis. With respect to other lines of business, TransRe assumes terrorism risk in marine, aviation and other casualty treaties after careful underwriting consideration and, in many cases, with limitations. Potential losses from acts of terrorism could be material depending on the nature and location of the act.

Approximately 3.5 percent of all policies and approximately 14.4 percent of property policies written by RSUI in 2012 contained coverage for domestic and foreign acts of terrorism. RSUI uses various underwriting strategies to mitigate its exposure to terrorism losses. In addition, its casualty reinsurance programs provide coverage for domestic and foreign acts of terrorism. The cost of property reinsurance for acts of terrorism has increased significantly in recent years and capacity is limited. RSUI’s property reinsurance programs provide coverage only for domestic acts of terrorism; as a result, RSUI remains liable for losses under property policies that provide coverage for foreign acts of terrorism, subject to Terrorism Act reimbursement.

Our Reinsurance Security Committee, which includes certain of our officers and the chief financial officers of each of our reinsurance and insurance operating units, meets to track, analyze and manage the use of reinsurance by our reinsurance and insurance operating units. The Reinsurance Security Committee considers and oversees the limits on the maximum amount of unsecured reinsurance recoverables that should be outstanding from any particular reinsurer, the lines of business that should be ceded to a particular reinsurer and, where applicable, the types of collateral that should be posted by reinsurers.

As of December 31, 2012, our reinsurance and insurance operating units had total reinsurance recoverables of $1,348.6 million of outstanding loss and LAE reserves and $42.7 million of recoverables on paid losses. The reinsurance purchased by our reinsurance and insurance operating units does not relieve them from their obligations to their cedants and policyholders, and therefore, the financial strength of their reinsurers is important. Approximately 92.5 percent of our reinsurance recoverables balance as of December 31, 2012 was due from reinsurers having an A.M. Best financial strength rating of “A” (Excellent) or higher. Our reinsurance and insurance operating units had no allowance for uncollectible reinsurance as of December 31, 2012. Information related to concentration of reinsurance recoverables can be found in Note 5(b) to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K. Information regarding the risks faced by our reinsurance and insurance operating units with respect to their use of reinsurance can be found on pages 41 and 42 of this Form 10-K.

Competition

The reinsurance and insurance industry is highly competitive. Competition in the businesses of our reinsurance and insurance operating units is based on many factors, including the perceived financial strength of the company, premium charges, other terms and conditions offered, services provided, commissions paid to producers, ratings assigned by independent rating agencies, speed of claims payment and reputation and experience in the lines to be written.

Our operating units that comprise the reinsurance and insurance segments compete with a large number of major U.S. and non U.S. reinsurers and insurers in their selected lines of business, including regional companies, mutual companies, specialty insurance companies, underwriting agencies, government-owned or subsidized facilities, European underwriting syndicates and diversified financial services companies. In our reinsurance segment, TransRe’s property and casualty businesses compete on a worldwide basis. In our insurance segment, RSUI’s property and casualty businesses and CATA’s surety and non-admitted specialty businesses compete on a national basis, CATA’s admitted property and casualty businesses compete on a regional basis, and PCC’s workers’ compensation insurance business competes primarily in California. Some of these competitors have significantly more premiums, capital and resources than our reinsurance and insurance operating units.

In addition to competition from the reinsurance industry, TransRe faces competition from the capital markets, as well as some traditional reinsurers, which from time to time produce alternative products or reinsurance vehicles (such as collateralized reinsurance, reinsurance securitizations, catastrophe bonds and various derivatives, such as swaps, and sidecars) that may compete with certain types of reinsurance, such as

 

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property catastrophe. Hedge funds may also provide reinsurance and retrocessional protections through captive companies or other alternative transactions on a fully collateralized basis for property and energy catastrophe business. Over time, these initiatives could significantly affect supply, pricing and competition in the reinsurance industry.

A discussion of the risks faced by our reinsurance and insurance operating units due to competition within, and the cyclicality of, the reinsurance and insurance business can be found on pages 40 and 41 of this Form 10-K.

Employees

As of December 31, 2012, we employed a total of 1,506 persons, with 14 persons employed at the parent company, 636 persons employed at TransRe, 778 persons employed at our insurance operating units, and 78 persons employed at our other subsidiaries.

Regulation

General

Our reinsurance and insurance companies are subject to extensive supervision and regulation in the jurisdictions in which they operate and are required to comply with a wide range of laws and regulations applicable to insurance and reinsurance companies, although the degree and type of regulation varies from jurisdiction to jurisdiction. We expect the scope and extent of regulation globally, as well as regulatory oversight generally, to continue to increase.

U.S. Regulation. Our reinsurance and insurance companies are regulated in all U.S. jurisdictions in which they conduct business. The extent of this regulation varies, but state insurance laws and regulations generally govern the licensing and financial condition of reinsurers and insurers, including standards of solvency, types and concentrations of permissible investments, establishment and maintenance of reserves, credit for reinsurance and requirements of capital adequacy. In addition, state insurance laws and regulations govern the business conduct of insurers, including marketing and sales practices and claims handling, and require the approval of policy forms, related materials and the rates for certain lines of insurance.

Through the “credit for reinsurance” mechanism, our reinsurance companies are indirectly subject to the effects of regulatory requirements imposed by the states in which their ceding insurers are licensed. In general, an insurer that obtains reinsurance from a reinsurer that is licensed, accredited or authorized by the state in which the insurer files statutory financial statements is permitted to take a credit on its statutory financial statements in an aggregate amount equal to the reinsurance recoverable on paid losses and the liabilities for unearned premiums and loss and LAE reserves ceded to the reinsurer, subject to certain limitations. Certain states impose additional requirements that make it difficult to become so authorized, and certain states do not allow credit for reinsurance ceded to reinsurers that are not licensed or accredited in that state without additional provision for security.

Insurance Holding Company Regulation. As an insurance holding company, we and our reinsurance and insurance companies are subject to regulation under the insurance holding company laws enacted in those states where our reinsurance and insurance companies are domiciled or where they conduct business. These laws generally require an insurance holding company and its reinsurer and insurer subsidiaries to register with their respective insurance regulators and to file with those regulators certain reports, including information concerning their capital structure, ownership, financial condition, certain intercompany transactions, including dividends and distributions, and general business operations. The insurance holding company laws of some states, including with respect to the payment of dividends and distributions, may be more restrictive than the insurance holding company laws of other states.

Under the insurance holding company laws and regulations, our reinsurance and insurance companies may not pay an “extraordinary” dividend or distribution, or pay a dividend except out of earned surplus, without the

 

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approval of state insurance regulators. In general, an “extraordinary” dividend or distribution is defined as a dividend or distribution that, together with other dividends and distributions made within the preceding 12 months, exceeds the greater (or, in some jurisdictions, the lesser) of (i) 10 percent of the insurer’s statutory surplus as of the immediately prior year end, and (ii) the statutory net income during the prior calendar year.

In addition, insurance holding company laws and regulations to which we and our reinsurance and insurance companies are subject generally require prior notification and approval or non-disapproval by the applicable insurance regulators of certain other significant transactions, including sales, loans, reinsurance agreements and service agreements between an insurer subsidiary, on the one hand, and its holding company or other subsidiaries of the holding company, on the other hand.

The insurance holding company laws and regulations of the states in which our reinsurance and insurance companies are domiciled also generally require that, before a person can acquire direct or indirect control of a reinsurer or an insurer domiciled in the state, prior written approval must be obtained from the insurer’s domiciliary state insurance regulator. The state insurance regulators are required to consider various factors, including the financial strength of the acquirer, the integrity and management experience of the acquirer’s board of directors and executive officers, and the acquirer’s plans for the future operations of the reinsurer or insurer. Pursuant to applicable laws and regulations, “control” over a reinsurer or an insurer is generally presumed to exist if any person, directly or indirectly, owns, controls, holds the power to vote or holds proxies representing, 10 percent or more of the voting securities of that reinsurer or insurer. Indirect ownership includes ownership of the shares of Alleghany’s common stock.

The acquisition of control laws described above may discourage potential acquisition proposals and may delay, deter or prevent an acquisition of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.

Amendments to Insurance Holding Company Regulation. In December 2010, the National Association of Insurance Commissioners, or “NAIC,” adopted amendments to the Model Insurance Holding Company System Regulatory Act and Regulation, or the “Amended Model Act and Regulation.” The Amended Model Act and Regulation introduces, among other things, the concept of “enterprise” risk within an insurance holding company system. If and when adopted by a particular state, the Amended Model Act and Regulation would impose more extensive informational requirements on the ultimate controlling person of the reinsurer or insurer with the purpose of protecting such insurer from enterprise risk, including requiring an annual enterprise risk report by the ultimate controlling person of the reinsurer or insurer that identifies the material risks within the insurance holding company system that could pose enterprise risk to the reinsurer or insurer. The Amended Model Act and Regulation must be adopted by the individual states, and specifically the states in which our reinsurance and insurance companies are domiciled, for the new requirements to apply. It is not clear when all U.S. states will adopt these changes; however, the Amended Holding Company Model Act and Regulation is expected to be adopted in full or in substantial part by all or most of the states by January 1, 2016.

Rates and Policy Forms. Our insurance companies’ policy forms and various premium rates and rates for property or casualty or surety insurance policies are subject to regulation in every state in which they conduct business. In many states, rates and policy forms must be filed with the applicable insurance regulator prior to their use, and in some states, rates and forms must be approved by the applicable insurance regulator prior to use.

The rates and coverage terms of reinsurance agreements with non-affiliates are generally not subject to regulation by any governmental authority. As a practical matter, however, the rates charged by primary insurers and the policy terms of primary insurance agreements may affect the rates charged and the policy terms under associated reinsurance agreements.

Market Conduct Examinations. The insurance laws and regulations to which our insurance companies are subject govern their marketplace activities, affecting the form and content of disclosure to consumers, product illustrations, advertising, product replacement, sales and underwriting practices and complaint and claims handling. These provisions are generally enforced through periodic market conduct examinations. Such insurance laws and regulations also govern the licensing of insurance companies and agents and regulate trade practices.

 

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Periodic Financial Reporting and Risk-Based Capital. Reinsurance and insurance companies in the U.S. are required to report their financial condition and results of operations in accordance with SAP prescribed or permitted by state insurance regulators in conjunction with the NAIC. State insurance regulators also prescribe the form and content of statutory financial statements, perform periodic financial examinations of reinsurers and insurers, set minimum reserve and loss ratio requirements, establish standards for permissible types and amounts of investments and require minimum capital and surplus levels. These statutory capital and surplus requirements include risk-based capital, or “RBC,” rules promulgated by the NAIC. These RBC standards are intended to assess the level of risk inherent in a reinsurance or an insurance company’s business and consider items such as asset risk, credit risk, underwriting risk and other business risks relevant to its operations. In accordance with RBC formulas, a company’s RBC requirements are calculated and compared with its total adjusted capital to determine whether regulatory intervention is warranted. As of December 31, 2012, the total adjusted capital of our U.S. domiciled reinsurance and insurance companies exceeded the minimum levels required under RBC rules, and each had excess capacity to write additional premiums in relation to these requirements.

The NAIC annually calculates certain statutory financial ratios for most reinsurance and insurance companies in the U.S. These calculations are known as the Insurance Regulatory Information System, or “IRIS,” ratios. There presently are thirteen IRIS ratios, with each ratio having an established “usual range” of results. The IRIS ratios assist state insurance departments in executing their statutory mandate to oversee the financial condition of insurance companies. A ratio falling outside the usual range is not considered a failing result; rather, unusual values are viewed as part of the regulatory early monitoring system. Furthermore, in some years, it may not be unusual for financially sound companies to have several ratios with results outside the usual ranges. The NAIC reports the ratios to state insurance departments who may then contact a company if four or more of its ratios fall outside the NAIC’s usual ranges. Based upon calculations as of December 31, 2012, PCIC had five of its ratios falling outside the NAIC’s usual ranges, due primarily to PCIC’s underwriting loss in 2012 and its adverse reserve development in 2012.

Guarantee Associations and Similar Arrangements. Certain U.S. insurance companies are required under the guaranty fund laws of most states in which they transact business to pay assessments up to certain prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies. Our U.S. insurance companies also are required to participate in various involuntary pools, principally involving workers’ compensation and windstorms.

Statutory Accounting Principles. State insurance regulators have developed SAP as a basis of accounting used to monitor and regulate the solvency of insurers. SAP is primarily concerned with measuring an insurer’s surplus to policyholders. Accordingly, SAP focuses on valuing assets and liabilities of an insurer at financial reporting dates in accordance with applicable insurance laws and regulations in the state in which such insurer is domiciled. SAP determines, among other things, the amount of statutory surplus and statutory net income of our reinsurance and insurance companies and thus determines, in part, the amount of funds they have available to pay as dividends.

GAAP is concerned with a company’s solvency, but it is also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses and accounting for management’s stewardship of assets than does SAP. Due to differences in methodology between SAP and GAAP, the values for assets, liabilities and equity reflected in financial statements prepared in accordance with GAAP are materially different from those reflected in financial statements prepared under SAP.

The NAIC has indicated it will consider policy positions regarding the new International Financial Reporting Standard, or “IFRS,” and its inclusion/exclusion from the U.S. framework of insurance solvency regulation and on the regulatory impacts of non-regulatory uses of statutory financial statements after completion of the insurance contracts joint project of the International Accounting Standards Board and the Financial Accounting Standards Board, or the “FASB,” and the SEC has made a decision regarding IFRS as a U.S. accounting standard for public companies. The potential outcomes identified by the NAIC include but are not limited to the replacement of SAP with GAAP with statutory adjustments or adoption of IFRS without adjustments. We will continue to monitor these developments and the impact they may have on our reinsurance and insurance companies.

 

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Legislative and Regulatory Initiatives. As discussed in more detail under “Reinsurance” above, the Terrorism Act established a federal assistance program to help the commercial property and casualty insurance industry cover claims arising from terrorism-related losses and regulates the terms of insurance relating to the terrorism coverage provided by our insurance companies.

On July 21, 2010, President Obama signed into law the Dodd-Frank Act. The Dodd-Frank Act made extensive changes to the laws regulating financial services firms and requires various federal agencies to adopt a broad range of new implementing rules and regulations. In addition to introducing sweeping reform of the U.S. financial services industry, the Dodd-Frank Act adopts certain changes to U.S. insurance regulation in general, and to non-admitted insurance and reinsurance in particular. While the Dodd-Frank Act does not result in the federal regulation of insurance, it does establish federal measures that will impact the reinsurance and insurance business and preempt certain state insurance measures. For example, the Dodd-Frank Act incorporates the Non-Admitted and Reinsurance Reform Act, or the “NRRA,” which became effective on July 21, 2011. Among other things, the NRRA established national uniform standards on how states may regulate and tax surplus lines insurance (and also sets national standards concerning the regulation of reinsurance). In particular, the NRRA gives regulators in the state where an insurer is domiciled exclusive authority to regulate and tax surplus lines insurance transactions, and regulators in a ceding insurer’s state of domicile are given the sole responsibility for regulating the balance sheet credit that the ceding insurer may take for reinsurance recoverables. At the present time, it is unclear what effect the NRRA changes specific to non-admitted insurance and reinsurance will have on our reinsurance and insurance companies, and there is still significant uncertainty as to how these and other provisions of the Dodd-Frank Act will be implemented in practice.

The Dodd-Frank Act also created the Federal Insurance Office, or the “FIO,” within the U.S. Department of Treasury, which is designed to promote national coordination within the insurance sector and which has the authority, in part, to monitor all aspects of the insurance industry, including identifying issues or gaps in the regulation of reinsurers and insurers that could contribute to a systemic crisis in the insurance industry or the U.S. financial system. The FIO also has the authority to enter into “Covered Agreements” with regulatory authorities outside the U.S. with respect to the supervision and regulation of the global reinsurance and insurance markets.

Federal agencies have been given significant discretion in drafting the rules and regulations that will implement the Dodd-Frank Act. In addition, the Dodd-Frank Act mandated multiple studies and reports for the U.S. Congress, which could in some cases result in additional legislative or regulatory action. We cannot predict the requirements of the regulations ultimately adopted under the Dodd-Frank Act or any related additional legislation, the additional costs resulting from compliance with such regulations or legislation, or any changes to our operations that may be necessary to comply with the Dodd-Frank Act.

In addition, a number of legislative and regulatory initiatives currently under consideration may significantly affect our reinsurance and insurance business in a variety of ways. These measures include, among other things, tort reform, consumer privacy requirements and proposals for the establishment of state or federal catastrophe funds. The impact of Super Storm Sandy, or “Sandy,” on the East Coast of the U.S. is likely to lead to increased calls for state and federal legislative and regulatory intervention in the reinsurance and insurance business especially in catastrophe prone areas.

International Regulation

General. TransRe is regulated in various foreign jurisdictions where it conducts business. In certain jurisdictions, TransRe operates through branches or representative offices of TRC and in other jurisdictions, TransRe has local reinsurance or insurance subsidiaries. TRC’s branch in the U.K. and its subsidiary in Switzerland, TRZ, comprise the largest component of TransRe’s international operations.

The extent of the regulation varies by foreign jurisdiction, but generally governs licensing requirements, currency, amount and type of security deposits, amount and type of reserves and amount and type of local investments. International operations and assets held abroad may be materially and adversely affected by economic, political and other developments in foreign countries, including possible changes in foreign and U.S. laws and regulations, nationalization and changes in regulatory policy, unexpected financial restrictions that

 

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foreign governments may impose and potential costs and difficulties in complying with a wide variety of foreign laws and regulations, as well as by the consequences of international hostilities and unrest. The risks of such occurrences and their overall effect upon us vary from country to country and cannot easily be predicted. Further, regulations governing technical reserves and remittance of balances in some countries may hinder remittance of profits and repatriation of assets.

U.K. Regulation. TransRe’s operations in the U.K. are conducted through a branch of TRC. TRC’s branch operations in the U.K. have been authorized by the Financial Services Authority in the United Kingdom, or the “FSA.” The FSA is the single statutory regulator responsible for regulating the financial services industry in respect of the carrying on of “regulated activities” (including insurance and reinsurance) in the U.K. Beginning April 1, 2013, these regulatory functions will be split between two new regulatory authorities, the Prudential Regulatory Authority, which will be responsible, among other things, for regulating the solvency of insurance and reinsurance companies, and the Financial Conduct Authority, which will be responsible, among other things, for regulating market conduct. The FSA has extensive powers to intervene in the affairs of an authorized person, including the power to enforce and take disciplinary measures in respect of breaches of its rules by authorized firms and approved persons. TRC is required to maintain a margin of solvency at all times in respect of the business conducted through the U.K. branch in accordance with the FSA rules. The calculation of the margin of solvency depends on the type and amount of reinsurance business written.

Swiss Regulation. TRZ is licensed to carry on reinsurance business in Switzerland. As a result, TRZ is required to comply with the Federal Insurance Supervision Act, the Federal Insurance Supervision Ordinance and the regulations and guidance issued by the Swiss Financial Market Supervisory Authority, or “FINMA.” Some of the significant aspects of the Swiss regulatory framework include complying with capital and solvency, corporate governance, risk management and internal control requirements. In addition, TRZ is subject to annual reporting requirements enacted by FINMA.

Branch Regulation. TRC operates in a number of other jurisdictions through a series of foreign branches, including branches in Australia, Bermuda, Canada, France, Germany, Japan and the Hong Kong Special Administrative Region of the People’s Republic of China. As a result, TRC is required, among other things, to meet local licensing, reserve, currency, investment and capital requirements for these branches.

Legislative and Regulatory Initiatives. Within the European Union, or the “EU,” the EU Reinsurance Directive of November 2005, or the “Reinsurance Directive,” was adopted. The Reinsurance Directive requires EU member states , or “Member States,” to lift barriers to trade within the EU for companies that are domiciled in a Member State. TRC operates within the EU as a “Third Country Reinsurer” through a series of foreign branches and on a cross-border basis. Each branch of TRC in the EU is separately authorized by the relevant regulator in the Member State in which it is established. Currently, TRC continues to conduct business within the EU through its foreign branches with no significant impact on its operations. However, TransRe could be materially and adversely affected by rules adopted by a Member State relating to Third Country Reinsurers. For example, TRC may be required to post additional collateral in EU countries or may need to consider restructuring its business in order to comply with the rules adopted in EU countries relating to Third Country Reinsurers.

In addition to the Reinsurance Directive, the EU is phasing in a new regime for the regulation of financial services known as “Solvency II.” Solvency II is a principles based regulatory regime that seeks to enhance transparency, promote uniformity, and encourage a proactive approach to company solvency. It is built on a risk-based approach to setting capital requirements of reinsurers and insurers. TransRe could be materially impacted by the implementation of Solvency II depending on the costs associated with implementation by each EU country, any increased capitalization requirements and any costs associated with adjustments to TransRe’s corporate operating structure. There is continuing uncertainty about Solvency II, including whether it will be adopted in its present form and the timing of its implementation. These uncertainties may increase the costs incurred by TransRe associated with preparing for the eventual adoption and implementation of Solvency II.

In Brazil, Argentina and India, three emerging markets where TransRe underwrites business on a cross-border basis, local regulations have recently been adopted that may operate to limit, restrict or increase the costs of TransRe’s access to these markets. If this trend continues to spread to other jurisdictions, TransRe’s ability to operate globally may be materially and adversely affected.

 

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We are also following the developments at the International Association of Insurance Supervisors, or the “IAIS,” which has a membership that includes insurance regulators and supervisors from over 190 jurisdictions in some 140 countries. The IAIS is not a regulator but has some influence on insurance regulation and standards in both mature and emerging markets. Currently, we are following the development and drafting of the Common Framework for the Supervision of Internationally Active Insurance Groups, a major project of the IAIS which, when finalized, may impose additional and duplicative supervisory and regulatory costs on our reinsurance and insurance companies. Additionally, the IAIS is drafting an issues paper regarding the supervision of branches that may influence TransRe’s ability to maintain or establish branches in markets outside the U.S.

Corporate Activities

Parent Company Operations

At the parent level, we seek out attractive investment opportunities, including strategic investments in operating companies, delegate responsibilities to competent and motivated managers at the operating business level, set goals for our operating businesses, assist managers in the achievement of these goals, define risk parameters and appropriate incentives for our operating businesses, and monitor progress against their long-term objectives.

Strategic investments currently include (i) an approximately 38 percent ownership stake in ORX, a regional oil and gas exploration and production company; and (ii) an approximately 33 percent stake in Homesite, a national, full-service, mono-line provider of homeowners insurance. We owned approximately 55 percent of Darwin Professional Underwriters, Inc., or “Darwin,” a specialty property and casualty insurer, until October 20, 2008, when it was merged with a subsidiary of Allied World Assurance Company Holdings, Ltd, or “AWAC.” As a result of our disposition of Darwin, that business has been reclassified as discontinued operations in this Form 10-K.

Alleghany Capital Partners

In March 2007, Alleghany Capital Partners was established to manage our public equity investments, including those held by our reinsurance and insurance operating units. For a discussion of our reinsurance and insurance operating units’ investment results, please see pages 65 and 66 of this Form 10-K. Alleghany Capital Partners also sources, executes, and monitors our private equity investments which include:

 

   

Bourn & Koch. On April 26, 2012, our majority-owned subsidiary Bourn & Koch acquired BKI, a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois.

 

   

Stranded Oil Resources Corporation. On June 5, 2011, we formed Stranded Oil Resources Corporation, an exploration and production company focused on enhanced oil recovery.

Alleghany Properties

Headquartered in Sacramento, California, Alleghany Properties owns and manages properties in Sacramento, California. These properties include primarily improved and unimproved commercial land, as well as residential lots. As of December 31, 2012, Alleghany Properties owned approximately 320 acres of property in various land use categories ranging from multi-family residential to commercial. In late 2010, Alleghany Properties began making investments in California low income housing tax credit limited liability companies. As of December 31, 2012, Alleghany Properties held investments in three such companies.

Item 1A. Risk Factors.

We face risks from our property and casualty reinsurance and insurance businesses and our investments in debt and equity securities, among others. Discussed below are significant risks that our businesses face. If any of the events or circumstances described as risks below actually occurs, our business, results of operations or financial condition could be materially and adversely affected. Our businesses may also be materially and adversely affected by risks and uncertainties not currently known to us or that we currently consider immaterial.

 

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Risk Factors Relating to our Business

The reserves for loss and LAE of our reinsurance and insurance operating units are estimates and may not be adequate, which would require our reinsurance and insurance operating units to establish additional reserves. Gross reserves for loss and LAE reported on our balance sheet as of December 31, 2012 were approximately $12.2 billion. These loss and LAE reserves reflect our best estimates of the cost of settling all claims and related expenses with respect to insured events that have occurred. Reserves do not represent an exact calculation of liability, but rather an estimate of what management expects the ultimate settlement and claims administration will cost for events that have occurred, whether known or unknown. These reserve estimates, which generally involve actuarial projections, are based on management’s assessment of facts and circumstances currently known and assumptions about anticipated loss emergence patterns, including expected future trends in claims severity and frequency, inflation, judicial theories of liability, reinsurance coverage, legislative changes and other factors.

The inherent uncertainties of estimating reserves are greater for certain types of liabilities, where long periods of time elapse before a definitive determination of liability is made and settlement is reached. Our liabilities for loss and LAE can generally be categorized into two distinct groups, short-tail business and long-tail business. Short-tail business refers to lines of business, such as property, for which losses are usually known and paid relatively shortly after the loss actually occurs. Long-tail business describes lines of business for which specific losses may not be known and reported for some period and losses take much longer to emerge. Given the time frame over which long-tail exposures are ultimately settled, there is greater uncertainty and volatility in these lines than in short-tail lines of business. Our long-tail coverages consist of most casualty lines including professional liability, D&O liability, general liability, umbrella/excess liability and certain workers’ compensation exposures. Some factors that contribute to the uncertainty and volatility of long-tail casualty business, and thus require a significant degree of judgment in the reserving process, include the inherent uncertainty as to the length of reporting and payment development patterns, the possibility of judicial interpretations or legislative changes that might impact future loss experience relative to prior loss experience and the potential lack of comparability of the underlying data used in performing loss reserve analyses. In general, reinsurance business for any particular line of business is longer-tailed and, by its nature, losses are more difficult to estimate than they are for comparable insurance business.

In periods with increased economic volatility, it becomes more difficult to accurately predict claims costs. It is especially difficult to estimate the impact of inflation on loss reserves given the current economic environment and related government actions. Reserve estimates are continually refined in an ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which the adjustments are made. Because setting reserves is inherently uncertain, we cannot assure you that our current reserves will prove adequate in light of subsequent events. Should our reinsurance and insurance operating units need to increase their reserves, our pre-tax income for the period would decrease by a corresponding amount. Although current reserves reflect our best estimate of the costs of settling claims, we cannot assure you that our reserve estimates will not need to be increased, perhaps by a material amount, in the future.

Because our reinsurance and insurance operating units are property and casualty reinsurers and insurers, we face losses from natural and man-made catastrophes. Property and casualty reinsurers and insurers are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition. Catastrophe losses, or the absence thereof, have historically had a significant impact on our results.

Natural or man-made catastrophes can be caused by various events, including hurricanes, other windstorms, earthquakes and floods, as well as terrorist activities. The incidence and severity of catastrophes in any short period of time are inherently unpredictable. The extent of gross 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. Most catastrophes are restricted to limited geographic areas; however, hurricanes, other windstorms, earthquakes and floods may produce significant damage when those areas are heavily populated. It is therefore possible that a catastrophic event or multiple catastrophic events could produce significant losses and have a material adverse effect on our financial condition and results of operations.

 

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In addition, longer-term natural catastrophe trends may be changing due to climate change, a phenomenon that has been associated with extreme weather events linked to rising temperatures, and includes effects on global weather patterns, greenhouse gases, sea, land and air temperatures, sea levels, rain and snow. Climate change, to the extent it produces rising temperatures and changes in weather patterns, could impact the frequency or severity of weather events such as hurricanes. To the extent climate change increases the frequency and severity of such weather events, our reinsurance and insurance operating units, particularly TransRe and RSUI, may face increased claims, particularly with respect to properties located in coastal areas. Our reinsurance and insurance operating units take certain measures to mitigate the impact of such events by considering these risks in their underwriting and pricing decisions, including their management of aggregate exposure levels, and through the purchase of reinsurance. To the extent broad environmental factors, exacerbated by climate change or otherwise, lead to increases in insured losses, particularly if those losses exceed the expectations of our insurance operating units, our financial condition and results of operations could be materially and adversely affected.

With respect to terrorism, to the extent that reinsurers have excluded coverage for certain terrorist acts or have priced this coverage at rates that are not practical, our insurance operating units, particularly RSUI, would not have reinsurance protection and would be exposed to potential losses as a result of any terrorist acts. To the extent an act of terrorism is certified by the U.S. Secretary of the Treasury, we may be covered under the Terrorism Act. This coverage under the Terrorism Act does not apply to reinsurers. Information regarding the Terrorism Act and its impact on our insurance operating units can be found on pages 31 and 32 of this Form 10-K.

TransRe does not provide cover for acts of terrorism that are certified under the Terrorism Act, but it is exposed to potential losses resulting from uncertified acts of terrorism in the United States or elsewhere, such as from terrorism-specific treaty coverage on a limited basis, and with respect to other lines of business from the assumption of terrorism risk in marine, aviation and other casualty treaties. Although TransRe assumes such terrorism risk after careful underwriting consideration and, in many cases, with limitations, a major terrorist event could have a material adverse impact on TransRe and Alleghany.

Finally, other catastrophes, such as an outbreak of a pandemic disease, the bankruptcy of a major company or a marine or aviation disaster, could also have a materially adverse effect on our business and operating results.

Significant competitive pressures may prevent our reinsurance and insurance operating units from retaining existing business or writing new business at adequate rates. Our reinsurance and insurance operating units compete with a large number of other companies in their selected lines of business. They compete, and will continue to compete, with major U.S. and non-U.S. insurers and reinsurers, other regional companies, mutual companies, specialty insurance companies, underwriting agencies, government-owned or subsidized facilities, European underwriting syndicates and diversified financial services companies. Many competitors have considerably greater financial resources and greater experience and may offer more products or services than do our reinsurance and insurance operating units. Except for regulatory considerations, there are virtually no barriers to entry into the reinsurance and insurance industry. Competition may be domestic or foreign, and competitors are not necessarily required to be licensed by their applicable regulators. Competition in the businesses of our reinsurance and insurance operating units is based on many factors, including the perceived financial strength of a company, premium charges, other terms and conditions offered, services provided, commissions paid to producers, ratings assigned by independent rating agencies, speed of claims payment and reputation and experience in the lines to be written. Such competition could cause the supply or demand for insurance to change, which could affect the ability of our reinsurance and insurance operating units to price their products at adequate rates. If our reinsurance and insurance operating units are unable to retain existing business or write new business at adequate rates, our results of operations could be materially and adversely affected.

In addition to competition from the reinsurance industry, TransRe faces competition from the capital markets, as well as some traditional reinsurers, which from time to time produce alternative products or reinsurance vehicles (such as reinsurance funds, catastrophe bonds and various derivatives, such as swaps, and sidecars) that may compete with certain types of reinsurance, such as property catastrophe. Hedge funds may also provide reinsurance and retrocessional protections through captive companies or other alternative transactions on a fully collateralized basis for property and energy catastrophe business. Over time, these numerous initiatives could significantly affect supply, pricing and competition in the reinsurance industry.

 

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Our results may fluctuate as a result of many factors, including cyclical changes in the reinsurance and insurance industries. Historically, the performance of the property and casualty reinsurance and insurance industries has tended to fluctuate in cyclical periods of price competition and excess underwriting capacity, followed by periods of high premium rates and shortages of underwriting capacity. Although an individual reinsurance and insurance company’s performance is dependent on its own specific business characteristics, the profitability of most property and casualty reinsurance and insurance companies tends to follow this cyclical market pattern. Further, this cyclical market pattern can be more pronounced in the reinsurance market in which TransRe competes and in the excess and surplus market in which RSUI primarily competes than in the standard insurance market. In addition, compared with historical cyclical periods, a cycle of increased price competition and excess underwriting capacity may continue for a prolonged period of time as new and existing reinsurance and insurance market participants and products continue to enter the reinsurance and insurance markets. Unfavorable market conditions may affect the ability of our reinsurance and insurance operating units to write business at rates they consider appropriate relative to the risk assumed. If we cannot write business at appropriate rates, our business would be significantly and adversely affected.

When premium rates are high and there is a shortage of capacity in the standard insurance market, growth in the excess and surplus market can be significantly more rapid than growth in the standard insurance market. Similarly, when there is price competition and excess underwriting capacity in the standard insurance market, many customers that were previously driven into the excess and surplus market may return to the standard insurance market, exacerbating the effects of price competition.

Demand for reinsurance is influenced significantly by underwriting and investment results in both the standard insurance and the excess and surplus markets and market conditions. The supply of reinsurance is related to prevailing prices, the levels of insured losses and the levels of reinsurance industry surplus, among other factors, that, in turn, may fluctuate in response to changes in rates of return on investments being earned in the reinsurance industry. In addition, the supply of reinsurance is affected by a reinsurer’s confidence in its ability to accurately assess the probability of expected underwriting outcomes, particularly with respect to catastrophe losses.

Since cyclicality is due in large part to the collective actions of insurers and reinsurers and general economic conditions and the occurrence of unpredictable events, we cannot predict the timing or duration of changes in the market cycle. These cyclical patterns cause our revenues and net earnings to fluctuate. In addition, our results may fluctuate as a result of changes in economic, legal, political and social factors, among others.

We cannot guarantee that the reinsurers used by our reinsurance and insurance operating units will pay in a timely fashion, if at all, and, as a result, we could experience losses even if reinsured. As part of their overall risk and capacity management strategy, our reinsurance and insurance operating units purchase reinsurance by transferring, or ceding, part of the risk that they have underwritten to a reinsurance company in exchange for part of the premium received by our operating units in connection with that risk. Although reinsurance makes the reinsurer liable to our reinsurance and insurance operating units to the extent the risk is transferred or ceded to the reinsurer, our reinsurance and insurance operating units remain liable for amounts not paid by a reinsurer. Reinsurers may not pay the reinsurance recoverables that they owe to our operating units or they may not pay these recoverables on a timely basis. This risk may increase significantly if these reinsurers experience financial difficulties as a result of catastrophes, investment losses or other events. Accordingly, we bear credit risk with respect to our reinsurance and insurance operating units’ reinsurers, and if they fail to pay, our financial results would be adversely affected. As of December 31, 2012, the amount due from reinsurers reported on our balance sheet was $1.3 billion.

If market conditions cause reinsurance to be more costly or unavailable, our reinsurance and insurance operating units may be required to bear increased risks or reduce the level of their underwriting commitments. As part of our overall risk management strategy, our operating units purchase reinsurance for certain amounts of risk underwritten by them, including catastrophe risks. The reinsurance programs purchased by our operating units are generally subject to annual renewal. Market conditions beyond their control determine the availability and cost of the reinsurance protection they purchase, which may affect the level of their business written and thus their profitability. If our operating units are unable to renew their expiring facilities or to obtain

 

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new reinsurance facilities, either their net exposures on future policies or reinsurance contracts would increase, which could increase the volatility of their results or, if they are unwilling or unable to bear an increase in net exposures, they would have to reduce the level of their underwriting commitments, especially catastrophe-exposed risks, which may reduce their revenues and net earnings. In certain reinsurance contracts, a cedant, to the extent it exhausts its original coverage under a reinsurance contract during a single coverage period (typically a single twelve-month period), can pay a reinsurance reinstatement premium to restore coverage during such coverage period. If our operating units exhaust their original and, if applicable, reinstated coverage under their third-party reinsurance contracts during a single coverage period, they will not have any reinsurance coverage available for losses incurred as a result of additional catastrophic events during that coverage period. The exhaustion of such reinsurance coverage could have a material adverse effect on the profitability of our operating units in any given period and on our results of operations.

TransRe and RSUI attempt to manage their exposure to catastrophe risk partially through the use of catastrophe modeling software. The failure of this software to accurately gauge the catastrophe-exposed risks they write could have a material adverse effect on our financial condition, results of operations and cash flows. As part of their approach to managing catastrophe risk, TransRe and RSUI use a number of tools, including third-party catastrophe modeling software, to help evaluate potential losses. TransRe and RSUI use modeled loss scenarios and internal analyses to set their level of risk retention and help structure their reinsurance programs. Modeled loss estimates, however, have not always accurately predicted their ultimate losses with respect to catastrophe events. Accordingly, they periodically review their catastrophe exposure management approach, which may result in the implementation of new monitoring tools and a revision of their underwriting guidelines and procedures. However, these efforts may not be successful in sufficiently mitigating risk exposures and losses resulting from future catastrophes.

Our reinsurance and insurance operating units are rated by rating agencies and a decline in these ratings could affect the standings of these units in the reinsurance and insurance industries and cause their premium volume and earnings to decrease. Ratings have become an increasingly important factor in establishing the competitive positions of reinsurance and insurance companies. Some of our reinsurance and insurance companies are rated by A.M. Best, S&P and/or Moody’s, which we collectively refer to as the “Rating Agencies.” Rating Agencies’ financial strength ratings reflect their opinions of a reinsurance or an insurance company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders, and are neither an evaluation directed to investors of a security nor a recommendation to buy, sell or hold a security. These ratings are subject to periodic review, and we cannot assure you that any of our reinsurance or insurance companies will be able to retain their current ratings. If the ratings of our reinsurance or insurance companies are reduced from their current levels by Rating Agencies, their competitive positions could suffer and it would be more difficult for them to market their products. A significant downgrade could result in a substantial loss of business as customers move to other companies with higher financial strength ratings.

In addition, in general, if the financial strength ratings of TRC from the Rating Agencies fall below “A-,” certain rating agency triggers in a significant portion of TRC’s contracts would allow customers to elect to take a number of actions such as terminating the contracts on a run-off or cut-off basis, requiring TransRe to post collateral for all or a portion of the obligations or requiring commutation under the contracts. Some of these contracts, however, contain dual triggers, such as requiring both a ratings downgrade below “A-” and a significant decline in the statutory surplus of TRC before such cancellation or collateralization rights would be exercisable. Contracts may contain one or both of the aforementioned contractual provisions, or certain other collateralization or cancellation triggers. Whether a ceding company would exercise any of these cancellation rights would depend on, among other factors, the reason and extent of such downgrade or surplus reduction, the prevailing market conditions and the pricing and availability of replacement reinsurance coverage. We cannot predict in advance the extent to which these contractual rights would be exercised, if at all, or what effect such exercises would have on our financial condition or future operations, but such effect potentially could be materially adverse.

When a contract is cancelled on a “cut-off” basis, the unearned premiums on that business as of the cut-off date are returned to the ceding company, net of a proportionate share of the original ceding commission. The amount of unearned premiums returned would be recorded as a reduction of gross premiums written with a like

 

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reduction in gross unearned premiums with no effect on gross premiums earned. Thus, the canceling of a contract generally has liquidity and future implications for TransRe’s business, but rarely affects premiums already earned.

TransRe may also enter into agreements with ceding companies that require TransRe to provide collateral for its obligations, including where TransRe’s obligations to these ceding companies exceed negotiated thresholds. These thresholds may vary depending on TRC’s ratings, and a ratings downgrade or a failure to achieve a certain rating may increase the amount of collateral TransRe is required to provide. TransRe may provide the collateral by delivering letters of credit to the ceding company, depositing assets into a trust for the benefit of the ceding company or permitting the ceding company to withhold funds that would otherwise be delivered to TRC under the reinsurance contract. The amount of collateral TransRe is required to provide typically represents all or a portion of the obligations TransRe may owe a ceding company, often including estimates made by a ceding company of IBNR claims. Since TransRe may be required to provide collateral based on a ceding company’s estimate, TransRe may be obligated to provide collateral that exceeds TransRe’s estimate of the ultimate liability to such ceding company. An increase in the amount of collateral TransRe is obligated to provide to secure its obligations may have an adverse impact on, among other things, TransRe’s ability to write additional reinsurance.

Certain counterparties of TransRe may acquire certain rights upon the change in control of us or TransRe, which could negatively affect us. TransRe is a party to numerous contracts, agreements, licenses, permits, authorizations and other arrangements that contain provisions giving counterparties certain rights (including, in some cases, termination rights) in the event of a change in control of us or TransRe. If a change in control occurs, cedants may be permitted to cancel contracts on a cut-off or run-off basis, and TransRe may be required to provide collateral to secure premium and reserve balances or may be required to cancel and commute the contract, subject to an agreement between the parties that may be settled in arbitration. If a contract is cancelled on a cut-off basis, TransRe may be required to return unearned premiums, net of commissions. In certain instances, contracts contain dual triggers, such as a change in control and a ratings downgrade, both of which must be satisfied for the contractual right to be exercisable.

Whether a ceding company would have cancellation rights in connection with a change in control of us or TransRe depends upon the language of its agreement with TransRe. Whether a ceding company exercises any cancellation rights it has would depend on, among other factors, such ceding company’s views with respect to the financial strength and business reputation of the new controlling party or other significant owners of the common stock of the new controlling party, the extent to which such ceding company has reinsurance coverage with such persons or their affiliates, the prevailing market conditions, the pricing and availability of replacement reinsurance coverage and TransRe’s ratings following the change in control.

In addition, contracts may provide a ceding company with multiple options, such as collateralization or commutation, that would be triggered by a change in control. Collateral requirements may take the form of trust agreements, funded by securities held, or letters of credit. Should cedants invoke the right to commute, an amount would be payable by TransRe to the respective ceding companies representing both a return of unearned premiums and a settlement of loss reserves, where applicable. Upon commutation, the amount to be paid to settle the liability for gross loss reserves may include a discount or premium to the financial statement loss reserve value.

If a change in control occurs, and cedants are permitted to cancel reinsurance contracts or require TransRe to provide collateral to secure significant reserve balances, and exercise these rights, such exercise could adversely affect our cash flows and results of operations.

A limited number of brokers account for a large portion of TransRe’s premiums; the loss of all or a substantial portion of the business provided by them may have an adverse effect on us. The great majority of TransRe’s premiums are written through brokers. Three large international brokers dominate the reinsurance brokerage industry, and TransRe derives a significant portion of its premiums from these brokers. The loss of all or a substantial portion of the business provided by these brokers could have a material adverse effect on us.

 

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Difficult and volatile conditions in the global capital and credit markets and in the overall economy could materially and adversely affect the results of our reinsurance and insurance operating units. Disruption and volatility in the global capital and credit markets and in the overall economy affects our business in a number of ways, including the following:

 

 

disruption in the capital and credit markets may increase claims activity in our reinsurance business, such as D&O, errors & omissions liability and trade credit lines;

 

 

volatility in the capital and credit markets makes it more difficult to access those markets, if necessary, to maintain or improve their financial strength and credit ratings or to generate liquidity;

 

 

disruption in the overall economy may reduce demand for reinsurance and insurance products; and

 

 

increases in inflation could result in higher losses on reinsurance contracts, particularly in longer- tailed lines of business, increased operating costs and a decrease in the fair value of our investment portfolio.

It is difficult to predict when and how long these types of conditions may exist and how our markets, business and investments will be adversely affected. Accordingly, these conditions could have a material adverse effect on our consolidated financial condition or results of operations in future periods.

The businesses of our reinsurance and insurance operating units are heavily regulated, and changes in regulation may reduce their profitability and limit their growth. Our operating units are subject to extensive regulation and supervision in the jurisdictions in which they conduct business, both in the United States and other countries. This regulation is generally designed to protect the interests of policyholders and not necessarily the interests of insurers, their stockholders or other investors. The regulation relates to authorization for lines of business, capital and surplus requirements, investment limitations, underwriting limitations, transactions with affiliates, dividend limitations, changes in control, premium rates and a variety of other financial and nonfinancial components of a reinsurance and insurance company’s business.

Virtually all states in which our insurance operating unit companies conduct their business require them, together with other insurers licensed to do business in that state, to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies. In addition, in various states, our insurance operating unit companies must participate in mandatory arrangements to provide various types of insurance coverage to individuals or other entities that otherwise are unable to purchase that coverage from private insurers. A few states require our insurance operating unit companies to purchase reinsurance from a mandatory reinsurance fund. Such reinsurance funds can create a credit risk for insurers if not adequately funded by the state and, in some cases, the existence of a reinsurance fund could affect the prices charged for the policies issued by our reinsurance and insurance operating units. The effect of these and similar arrangements could reduce the profitability of our insurance operating units in any given period or limit their ability to grow their business.

In recent years, the state insurance regulatory framework has come under increased scrutiny, and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Further, the NAIC and state insurance regulators are continually reexamining existing laws and regulations, specifically focusing on modifications to statutory accounting principles, interpretations of existing laws and the development of new laws and regulations. On the federal level, the Dodd-Frank Act, signed into law on July 2010, mandated significant changes to the regulation of U.S. insurance effective as of July 21, 2011. We cannot predict the requirements of the regulations ultimately adopted under the Dodd-Frank Act or the impact such regulations will have on our business. These regulations, and any proposed or future state or federal legislation or NAIC initiatives, if adopted, may be more restrictive on the ability of our reinsurance and insurance operating units to conduct business than current regulatory requirements or may result in higher costs.

TransRe’s offices that operate in jurisdictions outside the United States are subject to certain limitations and risks that are unique to foreign operations. TransRe’s international operations are also regulated in various jurisdictions with respect to licensing requirements, currency, amount and type of security deposits, amount and type of reserves, amount and type of local investments and other matters. International operations and assets held abroad are subject to significant legal, market, operational, compliance and regulatory risks, including risks related to:

 

 

economic, political and other developments in foreign countries;

 

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changes in foreign or U.S. tax laws;

 

 

complying, or monitoring compliance, with the requirements of the U.S. Foreign Corrupt Practices Act, and rules relating to trade sanctions of foreign governments or the United States, including trade sanctions administered by the U.S. Office of Foreign Assets Control;

 

 

nationalization and changes in regulatory policy;

 

 

unexpected financial restrictions that foreign governments may impose;

 

 

the potential costs and difficulties in complying with a wide variety of foreign laws and regulations; and

 

 

the consequences of international hostilities and unrest.

The risks of such occurrences and their overall effect upon us vary from country to country and cannot be predicted. In addition, our results of operations and net unrealized currency translation gain or loss (a component of accumulated other comprehensive income) are subject to volatility as the value of the foreign currencies fluctuate relative to the U.S. dollar. Further, regulations governing technical reserves and remittance balances in some countries may hinder remittance of profits and repatriation of assets.

Within the EU, the Reinsurance Directive, which requires Member States to lift barriers to trade within the EU for companies that are domiciled in a Member State, has been adopted. TRC operates within the EU as a Third Country Reinsurer through a series of foreign branches and on a cross-border basis. Each branch of TRC in the EU is separately authorized by the relevant regulator in the Member State in which it is established. Currently, TRC continues to conduct business within the EU through its foreign branches with no significant impact on its operations. However, TransRe could be materially and adversely affected by rules adopted by a Member State relating to Third Country Reinsurers. For example, TRC may be required to post additional collateral in EU countries or may need to consider restructuring its business in order to comply with the rules adopted in EU countries relating to Third Country Reinsurers.

In addition to the Reinsurance Directive, the EU is phasing in a new regulatory regime for regulation of financial services known as Solvency II. Solvency II is a principles-based regulatory regime that seeks to enhance transparency, promote uniformity, and encourage a proactive approach to company solvency. It is built on a risk-based approach to setting capital requirements of reinsurers and insurers. TransRe could be materially impacted by the implementation of Solvency II depending on the costs associated with implementation by each EU country, any increased capitalization requirements and any costs associated with adjustments to TransRe’s corporate operating structure.

In Brazil, Argentina and India, three emerging markets where TransRe underwrites business on a cross-border basis, local regulations have recently been adopted that may operate to limit, restrict or increase the costs of TransRe’s access to these markets. If this trend continues to spread to other jurisdictions, TransRe’s ability to operate globally may be materially and adversely affected.

The loss of key personnel at our reinsurance and insurance operating units could adversely affect our results of operations, financial condition and cash flows. We rely upon the knowledge and talent of the employees of our reinsurance and insurance operating units to successfully conduct their business. A loss of key personnel, especially the loss of underwriters or underwriting teams, could have a material adverse effect on our results of operations, financial condition and cash flows in future periods. Our success has depended, and will continue to depend in substantial part, upon our ability to attract and retain teams of underwriters in various business lines at our reinsurance and insurance operating units. The loss of key services of any members of current underwriting teams at our reinsurance and insurance operating units may adversely affect our business and results of operations.

The employees of our reinsurance and insurance operating units also rely upon access to their facilities to conduct their business. The inability by these employees to access their facilities over a prolonged time period could have a material effect on our results of operations, financial condition and cash flows in future periods.

 

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Risk Factors Relating to our Investments and Assets

The valuation of our investments includes methodologies, estimates and assumptions which are subject to differing interpretations or judgments; a change in interpretations or judgments could result in changes to investment valuations that may adversely affect our results of operations or financial condition. The vast majority of our investments are measured at fair value using methodologies, estimates and assumptions which are subject to differing interpretations or judgments. Financial instruments with quoted prices in active markets generally have more price observability and less judgment is used in measuring fair value. Conversely, financial instruments traded in other-than-active markets or that do not have quoted prices have less observability and are measured at fair value using valuation models or other pricing techniques that require more judgment. Investments recorded at fair value in the consolidated balance sheet are classified in a hierarchy for disclosure purposes consisting of three “levels” based on the observability of inputs available in the market used to measure the fair values.

Securities that are less liquid are more difficult to value and trade. During periods of market disruption, including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of the securities in our investment portfolio if trading becomes less frequent or market data becomes less observable. Certain asset classes in active markets with significant observable data may become illiquid due to changes in the financial environment. In such cases, valuing these securities may require more subjectivity and judgment. In addition, prices provided by third-party pricing services and broker quotes can vary widely even for the same security.

As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated, thereby resulting in values which may be greater or less than the value at which the investments may be ultimately sold. Further, rapidly changing or strained credit and equity market conditions could materially impact the value of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on our results of operations or financial condition.

A substantial amount of our assets is invested in debt securities and is subject to market fluctuations. A substantial portion of our investment portfolio consists of debt securities. As of December 31, 2012, our investment in debt securities was approximately $16.0 billion, or 87.3 percent of our total investment portfolio. The fair value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions. A rise in interest rates would decrease the net unrealized gain position of our debt securities portfolio and potentially produce a net unrealized loss position, offset by our ability to earn higher rates of return on reinvested funds. Conversely, a decline in interest rates would increase the net unrealized gain position of our debt securities portfolio, offset by lower rates of return on reinvested funds. Based upon the composition and duration of our investment portfolio as of December 31, 2012, a 100 basis point increase in interest rates would result in an approximate $615.9 million decrease in the fair value of our debt security investments. In addition, some debt securities, such as mortgage-backed and other asset-backed securities, carry prepayment risk, or the risk that principal will be returned more rapidly or slowly than expected, as a result of interest rate fluctuations.

Defaults, downgrades or other events impairing the value of our debt securities portfolio may reduce our earnings. We are subject to the risk that the issuers of debt securities we own may default on principal and interest payments they owe us. The occurrence of a major economic downturn, acts of corporate malfeasance, widening risk spreads or other events that adversely affect the issuers of these debt securities could cause the value of our debt securities portfolio and our net earnings to decline and the default rate of the debt securities in our investment portfolio to increase. In addition, with economic uncertainty, the credit quality of issuers could be adversely affected and a ratings downgrade of the issuers of the debt securities we own could also cause the value of our debt securities portfolio and our net earnings to decrease. Any event reducing the value of these securities other than on a temporary basis could have a material adverse effect on our business, results of operations and financial condition. We continually monitor the difference between cost and the estimated fair value of our investments in debt securities. If a decline in the value of a particular debt security is deemed to be temporary, we record the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, we write it down to the carrying value of the investment and record an other than temporary impairment loss in our statement of earnings, which may be material to our operating results.

 

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We invest some of our assets in equity securities, which are subject to fluctuations in market value. We invest a portion of our investment portfolio in equity securities which are subject to fluctuations in market value. As of December 31, 2012, our investments in equity securities had a fair value of approximately $1.4 billion, which represented 7.8 percent of our investment portfolio. We hold our equity securities as available-for-sale, and any changes in the fair value of these securities, net of tax, would be reflected in our accumulated other comprehensive income as a component of stockholders’ equity. If a decline in the value of a particular equity security is deemed to be temporary, we record the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, we write its cost-basis down to the fair value of the security and record an other than temporary impairment loss in our statement of earnings, which may be material to our operating results. A severe or prolonged downturn in equity markets could give rise to significant impairment charges.

As of December 31, 2012, our energy sector equity security holdings had an aggregate fair value of $542.2 million, which represented 38.1 percent of our equity portfolio. This investment concentration exposes us to risks in the energy sector, including price changes for oil and natural gas, which may lead to higher levels of price volatility and variability in the level of unrealized investment gains or losses.

Changes in foreign currency exchange rates could impact the value of our assets and liabilities denominated in foreign currencies. A principal exposure to foreign currency risk is our obligation to settle claims denominated in foreign currencies in the subject foreign currencies. The possibility exists that we may incur foreign currency exchange gains or losses when we ultimately settle these claims. To mitigate this risk, we maintain investments denominated in certain foreign currencies in which the claims payments will be made. To the extent we do not seek to hedge our foreign currency risk or our hedges prove ineffective, the resulting impact of a movement in foreign currency exchange rates could materially and adversely affect our results of operations or financial condition.

If any of our businesses do not perform well, we may be required to recognize an impairment of our goodwill or other intangible assets or to establish a valuation allowance against the deferred income tax asset, which could adversely affect our results of operations or financial condition. Goodwill represents the excess of the amount we paid to acquire subsidiaries and other businesses over the fair value of their net assets at the date of acquisition. We test goodwill at least annually for impairment. Impairment testing is performed based upon estimates of the fair value of the operating unit to which the goodwill relates. The fair value of the operating unit is impacted by the performance of the business. The performance of our businesses may be adversely impacted by prolonged market declines. If we determine the goodwill has been impaired, we must write down the goodwill by the amount of the impairment, with a corresponding charge to net earnings. Such write-downs could have a material adverse effect on our results of operations or financial position. A decrease in the expected future earnings of an operating unit could lead to an impairment of some or all of the goodwill or other long-lived assets associated with such operating units in future periods.

Deferred income tax represents the tax effect of the differences between the book and tax basis of assets and liabilities. Deferred tax assets are assessed periodically by management to determine if they are recoverable. Factors in management’s determination include the performance of the business including the ability to generate capital gains. If it is more likely than not that the deferred income tax asset will not be realized based on available information then a valuation allowance must be established with a corresponding charge to net earnings. Such charges could have a material adverse effect on our results of operations or financial position. Deterioration of financial market conditions could result in the impairment of long-lived assets and the establishment of a valuation allowance on our deferred income tax assets.

Risks Relating to our Senior Notes and the Credit Agreement

Our failure to comply with restrictive covenants contained in the indentures governing the Senior Notes (as defined on page 81 of this Form 10-K) or any other indebtedness, including indebtedness under our revolving credit facility and any future indebtedness, could trigger prepayment obligations, which could adversely affect our business, financial condition and results of operations. The indentures governing the Senior Notes contain covenants that impose restrictions on Alleghany and TransRe with respect to, among other things, the incurrence of liens on the capital stock of certain of our subsidiaries. In addition, the indentures

 

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governing the Senior Notes contain certain other covenants, including covenants to timely pay principal and interest, and the Credit Agreement (as defined on page 79 of this Form 10-K) also requires us to comply with certain covenants. Our failure to comply with such covenants could result in an event of default under the indentures, under the Credit Agreement or under any other debt agreement we may enter into in the future, which could, if not cured or waived, result in us being required to repay the Senior Notes, the indebtedness under the Credit Agreement or any other future indebtedness. As a result, our business, financial condition, results of operations and liquidity could be adversely affected.

To service our debt, we will require a significant amount of cash, which may not be available to us. Our ability to make payments on, or repay or refinance, our debt, including the Senior Notes, will depend largely upon the future performance and use of our corporate activities investment portfolio, and our future operating performance, including the operating performance of our subsidiaries. Our future performance, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. In addition, our ability to borrow funds in the future will depend on the satisfaction of the covenants in the indentures governing the Senior Notes, in the Credit Agreement and in other debt agreements we may enter into in the future. Under the Credit Agreement, we also need to maintain certain financial ratios. We cannot assure you that our business, including the operating performance of our subsidiaries, will generate sufficient cash flow from operations or that future borrowings will be available to us under the Credit Agreement or from other sources in an amount sufficient to enable us to pay our debt, including the Senior Notes, or to fund our other liquidity needs.

Item 1B. Unresolved Staff Comments.

None.

Item 2. Properties.

Alleghany’s principal executive offices are located in leased office space in New York, New York. TransRe leases office space in each of its locations throughout the world. RSUI leases office space in Atlanta, Georgia for its headquarters and office space in Sherman Oaks, California. CATA leases office space in Middleton, Wisconsin for its and Platte River’s headquarters. PCC leases office space in Agoura Hills, California. Management considers its office facilities suitable and adequate for the current level of operations.

Item 3. Legal Proceedings.

Our subsidiaries are parties to pending litigation and claims in connection with the ordinary course of their businesses. Each such subsidiary makes provisions for estimated losses to be incurred in such litigation and claims, including legal costs. We believe such provisions are adequate and do not believe that any pending litigation will have a material adverse effect on our consolidated results of operations, financial position or cash flows.

Litigation Related to the Merger

In connection with the merger, Alleghany, Merger Sub and Old TransRe, among others, were named as defendants in three putative stockholder class action lawsuits filed by TransRe stockholders. Such lawsuits challenged the merger and alleged that Alleghany, Merger Sub and Old TransRe aided and abetted an alleged breach of fiduciary duty by Old TransRe’s board of directors in connection with the merger, among other allegations.

On January 30, 2012, Alleghany and the other defendants entered into a memorandum of understanding with the plaintiffs regarding the settlement of these putative stockholder class actions against Alleghany, Merger Sub, Old TransRe, Old TransRe’s directors, and AWAC, among others. Pursuant to the terms of the proposed settlement, certain supplemental disclosures were made related to the merger. The memorandum of understanding contemplated that the parties would enter into a stipulation of settlement. On October 12, 2012, the parties entered into a stipulation of settlement that includes customary conditions, including court approval following notice to Old TransRe’s stockholders. On January 10, 2013, a hearing was held before the Court of

 

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Chancery of the State of Delaware to consider the fairness, reasonableness, and adequacy of the settlement, as well as plaintiffs’ counsel’s petition for an award of attorneys’ fees and expenses not to exceed $0.5 million, to be paid, or cause to be paid, by TransRe. At the hearing, the Chancellor declined to approve the settlement, but granted plaintiffs’ counsel an opportunity to make a supplemental submission addressing the materiality of the supplemental disclosures made in connection with the settlement. Another settlement hearing has not yet been scheduled. If the settlement is finally approved by the court, it will resolve and release all claims in all actions that were or could have been brought challenging any aspect of the merger, the Merger Agreement, and any disclosure made in connection therewith (but excluding claims for appraisal under Section 262 of the Delaware General Corporation Law), among other claims. There can be no assurance that the Court of Chancery of the State of Delaware will approve the settlement. In such event, the proposed settlement as contemplated by the stipulation of settlement may be terminated.

Settlement by TransRe with AIG

On January 26, 2012, TransRe reached an agreement with American International Group, Inc., or “AIG,” to settle and mediate a dispute previously in arbitration, which arose as a result of losses claimed by TransRe from its participation in a securities lending program administered and managed by AIG. On July 20, 2012, in accordance with the agreement between the parties, a mediator awarded TransRe a settlement payment of $75.0 million with respect to the securities lending claim. In connection with its accounting for the acquisition of TransRe, Alleghany established an asset of $36.0 million, representing an estimate based on the minimum recovery previously agreed to by the parties, net of estimated legal costs. A pre-tax net benefit of approximately $23.5 million resulting from this settlement was recorded as other income in 2012, representing the portion of the settlement payment above such minimum recovery, net of additional estimated legal costs.

Item 4. Mine Safety Disclosures.

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information, Holders and Dividends

The following table indicates quarterly high and low sale prices of our common stock on the New York Stock Exchange in 2012 and 2011. Our ticker symbol is Y.

 

     2012      2011  

Quarter Ended

   High      Low      High      Low  

March 31

   $ 338.95       $ 281.51       $ 333.50       $ 298.09   

June 30

     346.70         318.43         337.36         324.20   

September 30

     359.85         328.19         334.83         279.88   

December 31

     364.89         313.85         321.57         277.15   

As of February 15, 2012, there were 936 holders of record of our common stock.

In light of the merger with TransRe, our Board of Directors determined not to declare a dividend for 2012. In 2011, our Board of Directors declared a dividend on our common stock consisting of one share of our common stock for every 50 shares outstanding.

Purchases of Equity Securities by Us

The following table summarizes our common stock repurchases for the quarter ended December 31, 2012:

 

      Total Number of
Shares Repurchased
     Average Price
Paid per Share
     Total Number of
Shares Purchased as
Part of Publicly
Anounced Plans or
Programs*
     Approximate Dollar
Value of Shares
That May Yet Be
Purchased Under the
Plans or

Programs
(in millions)*
 

October 1 to October 31

           $               $ 300.0   

November 1 to November 30

                           $ 300.0   

December 1 to December 31

     53,346         333.08         53,346       $ 282.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     53,346       $ 333.08         53,346       $ 282.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

* In October 2012, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.

 

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Performance Graph

The following information is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to the liabilities of Section 18 of the Exchange Act, and the information shall not be deemed to be incorporated by reference in any filing by us under the Securities Act of 1933 or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

The following graph compares (i) the cumulative total stockholder return on our common stock; (ii) the cumulative total return on the Standard & Poor’s 500 Stock Index, or the “S&P 500 Index;” and (iii) the cumulative total return on the Standard & Poor’s 500 Property and Casualty Insurance Index, or the “P&C Index,” for the five period beginning on December 31, 2007 through December 31, 2012. The graph assumes that the value of the investment was $100 on December 31, 2007.

 

LOGO

 

      Base
Period
12/31/07
    

INDEXED RETURNS

Years Ending

 
Company / Index       12/31/08      12/31/09      12/31/10      12/31/11      12/31/12  

Alleghany Corporation

     100         71.55         71.43         80.88         76.82         90.32   

S&P 500 Index

     100         63.00         79.67         91.68         93.61         108.59   

P&C Index

     100         70.59         79.30         86.39         86.18         103.51   

The graph above is based on the following assumptions: (i) cash dividends are reinvested on the ex-dividend date in respect of such dividend; and (ii) the two-percent stock dividends we have paid in each of the years 2008 through 2011 are included in the cumulative total stockholder return on our common stock.

 

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Item 6. Selected Financial Data.

Alleghany Corporation and Subsidiaries(1)

 

     Years Ended December 31,  
     2012      2011      2010      2009      2008  
     (in millions, except per share and share amounts)  

Operating Data

              

Revenue from continuing operations

   $ 4,753.2       $ 981.8       $ 985.4       $ 1,184.4       $ 989.1   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Earnings from continuing operations

   $ 702.2       $ 143.3       $ 198.5       $ 271.0       $ 40.6   

Earnings from discontinued operations

                                     107.4   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Net earnings

   $ 702.2       $ 143.3       $ 198.5       $ 271.0       $ 148.0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings per share of common stock(2)

              

Continuing operations

   $ 45.48       $ 16.26       $ 21.85       $ 29.25       $ 2.65   

Discontinued operations

                                     12.18   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Net earnings

   $ 45.48       $ 16.26       $ 21.85       $ 29.25       $ 14.83   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Average number of shares of common stock(2)

     15,441,578         8,807,487         9,081,535         9,055,920         8,822,449   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     As of December 31,  
     2012      2011      2010      2009      2008  
     (in millions, except per share amounts)  

Balance Sheet

              

Total assets

   $ 22,808.0       $ 6,478.1       $ 6,431.7       $ 6,192.8       $ 6,181.8   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Debt

   $ 1,811.5       $ 299.0       $ 298.9       $       $   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Common stockholders’ equity

   $ 6,403.8       $ 2,925.7       $ 2,908.9       $ 2,717.5       $ 2,347.3   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Common stockholders’ equity per share of common stock(2)

   $ 379.13       $ 342.12       $ 325.31       $ 294.79       $ 267.37   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) On April 26, 2012, we acquired BKI. On March 6, 2012, we acquired TransRe. We sold Darwin on October 20, 2008. Darwin has been reclassified as discontinued operations for the year ended 2008 and discontinued operations, net of minority interest expense, includes the gain on disposition in 2008.

 

(2) Amounts have been adjusted for subsequent common stock dividends.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

We are a Delaware corporation which owns and manages operating subsidiaries and investments, anchored by a core position in property and casualty reinsurance and insurance. We were incorporated in 1984 under the laws of the State of Delaware and in December 1986, we succeeded to the business of our parent company, Alleghany Corporation, which was incorporated in 1929.

Prior to March 6, 2012, Alleghany was primarily engaged, through AIHL and its subsidiaries, in the property and casualty insurance business. AIHL’s insurance operations are principally conducted by its subsidiaries RSUI, CATA and PCC. CATA has been a subsidiary of AIHL since January 2002, and RSUI has been a subsidiary of AIHL since July 2003. In June 2006, AIHL Re was established as a captive reinsurance subsidiary of AIHL, and AIHL Re has, in the past, provided reinsurance to our insurance operating units and affiliates. PCC has been a subsidiary of AIHL since July 18, 2007.

On March 6, 2012, or the “Acquisition Date,” pursuant to an Agreement and Plan of Merger, or the “Merger Agreement,” among Alleghany, our wholly-owned subsidiary, Shoreline Merger Sub, LLC (subsequently converted into a corporation), or “Merger Sub,” and Transatlantic Holdings, Inc., or “Old TransRe,” Old TransRe was merged with and into Merger Sub, or the “merger.” As a result of the merger, Merger Sub was renamed “Transatlantic Holdings, Inc.,” and Old TransRe became our wholly-owned subsidiary. Pursuant to the terms of the Merger Agreement, former stockholders of Old TransRe were entitled to receive, in exchange for each share of Old TransRe common stock held, either shares of our common stock or cash consideration with a value equal to approximately $61.14. On the Acquisition Date, we paid to the former stockholders of Old TransRe total consideration of approximately $3.5 billion, consisting of cash consideration of $816.0 million and stock consideration of 8,360,959 shares of our common stock. Our reinsurance operations began immediately following the merger. See Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on the merger.

Our primary sources of revenues and earnings are our reinsurance and insurance operations and investments. We also seek out strategic investments and conduct other activities at the parent level. Strategic investments currently include, among others, an approximately 33 percent stake in Homesite, a national, full-service, mono-line provider of homeowners insurance, and an approximately 38 percent stake in ORX, a regional gas and oil exploration and production company. Primarily through our wholly-owned subsidiary, Alleghany Capital Partners, we manage, source, execute, and monitor our private equity investments. On April 26, 2012, our majority-owned subsidiary Bourn & Koch acquired BKI, a manufacturer and remanufacturer/retrofitter of precision machine tools and supplier of replacement parts, headquartered in Rockford, Illinois. We own and manage land in the Sacramento, California region through our subsidiary Alleghany Properties.

As of December 31, 2012, Alleghany had total assets of $22.8 billion and total stockholders’ equity of $6.4 billion. As of December 31, 2012, we had consolidated total investments of approximately $18.3 billion, of which $16.0 billion was invested in debt securities, $1.4 billion was invested in equity securities, $0.5 billion was invested in other invested assets, and $0.4 billion was invested in short-term investments.

Segment Information

Alleghany’s segments are reported in a manner consistent with the way management evaluates the businesses. As such, Alleghany classifies its business into two reportable segments, reinsurance and insurance. Reinsurance and insurance underwriting activities are evaluated separately from investment and corporate activities. The primary components of “corporate activities” are Alleghany Properties, Alleghany’s investments in Homesite and ORX and strategic investments and other activities at the parent level. As of April 26, 2012, corporate activities also includes the operating results of BKI. See below and Note 13 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for an analysis of our underwriting results by segment and corporate activities, and ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations.’’

 

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Profitability

The profitability of our reinsurance and insurance operating units, and as a result, our profitability, is primarily impacted by the adequacy of premium rates, level of catastrophe losses, investment returns, intensity of competition and the cost of reinsurance. 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 ultimate adequacy of premium rates is not known with certainty at the time reinsurance contracts are entered into or property and casualty insurance policies are issued because premiums are determined before claims are reported.

The profitability of our reinsurance and insurance operating units is also impacted by competition generally and price competition in particular. Historically, the performance of the property and casualty reinsurance and insurance industries has tended to fluctuate in cyclical periods of price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. Although an individual reinsurance or an insurance company’s performance is dependent on its own specific business characteristics, the profitability of most property and casualty reinsurance and insurance companies tends to follow this cyclical market pattern. The property and casualty reinsurance and insurance industry has also been highly competitive in recent years, although, following significant catastrophe events in the past three years, property catastrophe rates improved in 2012. Terms and conditions for casualty reinsurance lines largely remained stable in 2012 and rate movements were mixed, with some lines improving and others experiencing downward pressure.

Catastrophe Risk

Catastrophe losses, or their absence, can have a significant impact on our results. For example, pre-tax catastrophe losses, net of reinsurance and reinstatement premiums, were $448.7 million in 2012, $74.3 million in 2011 and $31.0 million in 2010. Catastrophe losses in 2012 include a $412.0 million loss from Sandy, which caused widespread property damage and flooding to large areas of the East Coast and northeastern United States in October 2012. Our recorded loss for Sandy is based on an analysis of reported claims, an underwriting review of in-force contracts, estimates of losses resulting from wind and other perils, including storm surge and flooding to the extent covered by applicable policies, and other factors requiring considerable judgment. The ultimate loss from Sandy may be materially different from our estimate due to the size and complexity of the event and the preliminary nature of the information available to prepare the estimate.

The incidence and severity of catastrophes in any short period of time are inherently unpredictable. Catastrophes can cause losses in a variety of our property and casualty lines of business. We have significant exposure to both natural disasters, such as hurricanes, other windstorms and earthquakes, as well as man-made disasters. Longer-term natural catastrophe trends may be changing due to climate change, a phenomenon that has been associated with extreme weather events linked to rising temperatures, and includes effects on global weather patterns, sea, land and air temperatures, sea levels, rain and snow. Climate change, to the extent it produces rising temperatures and changes in weather patterns, could impact the frequency or severity of weather events such as hurricanes, other windstorms and tornado activity. To the extent climate change increases the frequency and severity of such weather events, our reinsurance and insurance operating units may face increased claims, particularly with respect to properties located in coastal areas.

As part of their overall risk and capacity management strategy, our reinsurance and insurance operating units take certain measures to mitigate the impact of catastrophe events through various means including considering catastrophe risks in their underwriting and pricing decisions, purchasing reinsurance, monitoring and modeling accumulated exposures, and managing exposure in key geographic zones and product lines that are prone to catastrophic events.

The reinsurance programs purchased by our reinsurance and insurance operating units are generally subject to annual renewal. Market conditions beyond the control of our reinsurance and insurance operating units determine the availability and cost of the reinsurance protection they purchase, which may affect the level of business written and thus their profitability.

 

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Comment on Non-GAAP Financial Measures

Throughout this Form 10-K, our analysis of our financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with GAAP. Our results of operations have been presented in the way that we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use financial information in evaluating the performance of Alleghany. This presentation includes the use of underwriting profit, which is a “non-GAAP financial measure,” as such term is defined in Item 10(e) of Regulation S-K promulgated by the SEC. Underwriting profit represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP and does not include net investment income, net realized capital gains, other than temporary impairment, or “OTTI,” losses, other income, other operating expenses, amortization of intangible assets or interest expense. We consistently use underwriting profit as a supplement to earnings before income taxes, the most comparable GAAP financial measure, to evaluate the performance of our segments and believe that underwriting profit provides useful additional information to investors because it highlights net earnings attributable to a segment’s underwriting performance. Earnings before income taxes may show a profit despite an underlying underwriting loss, and when underwriting losses persist over extended periods, a reinsurance or an insurance company’s ability to continue as an ongoing concern may be at risk. However, underwriting profit is not meant to be considered in isolation or as a substitute for earnings before income taxes or any other measures of operating performance prepared in accordance with GAAP. A reconciliation of underwriting profit to earnings before income taxes is presented within “Consolidated Results of Operations.”

 

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Consolidated Results of Operations

The following table summarizes our consolidated revenues, costs and expenses and earnings (in millions).

 

     Years Ended December 31,  
     2012     2011     2010  

Revenues

      

Net premiums earned

   $ 3,733.0      $ 747.6      $ 768.1   

Net investment income

     313.0        108.9        125.0   

Net realized capital gains

     157.9        127.1        97.4   

Other than temporary impairment losses

     (2.9     (3.6     (12.3

Gain on bargain purchase

     494.9                 

Other income

     57.3        1.8        7.2   
  

 

 

   

 

 

   

 

 

 

Total revenues

   $ 4,753.2      $ 981.8      $ 985.4   
  

 

 

   

 

 

   

 

 

 

Costs and Expenses

      

Net loss and loss adjustment expenses

     2,630.3        430.0        377.9   

Commissions, brokerage and other underwriting expenses

     882.4        268.1        259.3   

Other operating expenses

     123.7        31.1        33.8   

Corporate administration

     75.8        41.0        28.9   

Amortization of intangible assets

     253.3        3.4        3.4   

Interest expense

     68.4        17.4        4.7   
  

 

 

   

 

 

   

 

 

 

Total costs and expenses

   $ 4,033.9      $ 791.0      $ 708.0   
  

 

 

   

 

 

   

 

 

 

Earnings before income taxes

     719.3        190.8        277.4   

Income taxes

     17.1        47.5        78.9   
  

 

 

   

 

 

   

 

 

 

Net earnings

   $ 702.2      $ 143.3      $ 198.5   
  

 

 

   

 

 

   

 

 

 

Revenues:

      

Total reinsurance and insurance segments

   $ 4,191.6      $ 941.8      $ 978.2   

Corporate activities*

     561.6        40.0        7.2   

Earnings before income taxes:

      

Total reinsurance and insurance segments

   $ 295.6      $ 214.0      $ 306.6   

Corporate activities*

     423.7        (23.2     (29.2

 

* Consists of Alleghany Properties, our investments in Homesite and ORX and corporate activities at the parent level, including the gain on bargain purchase in connection with the merger, and due diligence, legal, investment banking and other merger-related costs, or “Transaction Costs.” As of April 26, 2012, corporate activities also includes the operating results of BKI. Corporate activities also includes interest expense associated with the Alleghany Senior Notes, whereas interest expense associated with the TransRe Senior Notes is included in “Total Segments.”

Our earnings before income taxes in 2012 increased from 2011, primarily reflecting the impact of the merger, partially offset by higher catastrophe losses. The impact of the merger included the gain on bargain purchase and increases in net premiums earned, net investment income and other income, which were partially offset by increases in net loss and LAE (which include catastrophe losses in 2012 discussed below), commissions, brokerage and other underwriting expenses, other operating expenses, corporate administration, amortization of intangible assets and interest expense. The gain on bargain purchase reflects the excess of the fair value of the net assets of TransRe we acquired over the purchase price we paid for such assets. The increase in corporate administration expense primarily reflects the impact of Transaction Costs of $33.8 million in 2012 in connection with the merger, compared with $19.3 million incurred in 2011. See Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional discussion of the merger and the related gain on bargain purchase and Transaction Costs. Catastrophe losses, net of reinsurance and reinstatement premiums, were $448.7 million in 2012 (including a $412.0 million loss from Sandy), compared with $74.3 million in 2011. Net realized capital gains in 2012 include a $63.1 million gain from the sale of our holdings of

 

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Exxon Mobil Corporation, or “Exxon Mobil,” common stock in January 2012. Other income in 2012 included a $23.5 million gain from a TransRe legal settlement, of a dispute (see “Legal Proceedings” set forth in Part I, Item 3 of this Form 10-K for additional discussion of this settlement).

Our earnings before income taxes in 2011 decreased from 2010, primarily reflecting higher loss and LAE, lower net premiums earned and lower net investment income, partially offset by higher net realized capital gains. The increase in loss and LAE primarily reflects a $28.7 million increase in PCC’s prior year reserves and higher catastrophe and other large property losses at RSUI in the 2011 period, partially offset by a higher net release of prior year casualty reserves by RSUI. The decrease in net premiums earned reflects the impact of continuing competition at CATA, as well as a reduction in net premiums written in certain specialty classes of business by CATA. The decrease in net investment income is due primarily to an increase in catastrophe losses related to our investment in Homesite, partially offset by higher dividend income.

The effective tax rate was 2.4 percent for 2012, 24.9 percent for 2011 and 28.4 percent for 2010. The lower effective tax rate in 2012 primarily reflects the impact of the non-taxable gain on bargain purchase and, to a lesser extent, the impact of higher tax-exempt interest income generated by TransRe from the Acquisition Date through December 31, 2012, partially offset by the impact of certain non-deductible Transaction Costs. The gain on bargain purchase resulted in a significant increase in earnings before income taxes without a corresponding increase in income taxes, whereas certain non-deductible Transaction Costs resulted in losses before income taxes without a corresponding decrease in income taxes. The lower effective tax rate in 2011 primarily reflects the impact of higher dividends received deductions and lower pre-tax earnings in 2011, partially offset by the absence of a foreign tax benefit which was significant in 2010.

 

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Total Reinsurance and Insurance Segment Results

The following tables summarize results of our reinsurance and insurance segments.

 

     Reinsurance     Insurance     Total(1)  
Year Ended December 31, 2012    (in millions, except ratios)  

Gross premiums written

   $ 2,940.2      $ 1,300.9      $ 4,241.1   

Net premiums written

     2,840.7        883.2        3,723.9   

Net premiums earned

   $ 2,915.9      $ 817.1      $ 3,733.0   

Net loss and LAE

     2,058.1        572.2        2,630.3   

Commissions, brokerage and other underwriting expenses

     591.1        291.3        882.4   
  

 

 

   

 

 

   

 

 

 

Underwriting profit (loss)(2)

   $ 266.7      $ (46.4     220.3   
  

 

 

   

 

 

   

Net investment income

         317.5   

Net realized capital gains

         117.9   

Other than temporary impairment losses

         (2.9

Gain on bargain purchase

           

Other income

         26.1   

Other operating expenses

         89.2   

Corporate administration

           

Amortization of intangible assets

         253.3   

Interest expense

         40.8   
      

 

 

 

Earnings before income taxes

       $ 295.6   
      

 

 

 

Loss ratio(3)

     70.6     70.0     70.5

Expense ratio(4)

     20.3     35.7     23.6
  

 

 

   

 

 

   

 

 

 

Combined ratio(5)

     90.9     105.7     94.1
  

 

 

   

 

 

   

 

 

 

 

     Reinsurance      Insurance     Total(1)  
Year Ended December 31, 2011    (in millions, except ratios)  

Gross premiums written

   $       $ 1,141.0      $ 1,141.0   

Net premiums written

             774.7        774.7   

Net premiums earned

   $       $ 747.6      $ 747.6   

Net loss and LAE

             430.0        430.0   

Commissions, brokerage and other underwriting expenses

             268.1        268.1   
  

 

 

    

 

 

   

 

 

 

Underwriting profit(2)

   $       $ 49.5        49.5   
  

 

 

    

 

 

   

Net investment income

          117.4   

Net realized capital gains

          79.7   

Other than temporary impairment losses

          (3.6

Gain on bargain purchase

            

Other income

          0.7   

Other operating expenses

          26.2   

Corporate administration

            

Amortization of intangible assets

          3.4   

Interest expense

          0.1   
       

 

 

 

Earnings before income taxes

        $ 214.0   
       

 

 

 

Loss ratio(3)

     n/a         57.5     57.5

Expense ratio(4)

     n/a         35.9     35.9
  

 

 

    

 

 

   

 

 

 

Combined ratio(5)

     n/a         93.4     93.4
  

 

 

    

 

 

   

 

 

 

 

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     Reinsurance      Insurance     Total(1)  
Year Ended December 31, 2010    (in millions, except ratios)  

Gross premiums written

   $       $ 1,104.0      $ 1,104.0   

Net premiums written

             736.2        736.2   

Net premiums earned

   $       $ 768.1      $ 768.1   

Net loss and LAE

             377.9        377.9   

Commissions, brokerage and other underwriting expenses

             259.3        259.3   
  

 

 

    

 

 

   

 

 

 

Underwriting profit(2)

   $       $ 130.9        130.9   
  

 

 

    

 

 

   

Net investment income

          128.9   

Net realized capital gains

          92.9   

Other than temporary impairment losses

          (12.3

Gain on bargain purchase

            

Other income

          0.6   

Other operating expenses

          31.3   

Corporate administration

            

Amortization of intangible assets

          3.4   

Interest expense

          (0.3
       

 

 

 

Earnings before income taxes

        $ 306.6   
       

 

 

 

Loss ratio(3)

     n/a         49.2     49.2

Expense ratio(4)

     n/a         33.8     33.8
  

 

 

    

 

 

   

 

 

 

Combined ratio(5)

     n/a         83.0     83.0
  

 

 

    

 

 

   

 

 

 

 

(1) Excludes elimination of minor reinsurance activity between segments (which is reported in corporate activities).

 

(2) Represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, OTTI losses, other income, other operating expenses, amortization of intangible assets or interest expense. Underwriting profit is a non-GAAP financial measure and does not replace net earnings determined in accordance with GAAP as a measure of profitability (see “Comment on Non-GAAP Financial Measures”).

 

(3) Net loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.

 

(4) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.

 

(5) The sum of the loss ratio and expense ratio, all as determined in accordance with GAAP, representing the percentage of each premium dollar a reinsurance or insurance company has to spend on net loss and LAE, and commission, brokerage and other underwriting expenses.

Earnings before income taxes for our reinsurance and insurance segments in 2012 increased from 2011, primarily reflecting the impact of the merger and higher net realized capital gains, partially offset by higher catastrophe losses. The impact of the merger included increases in net premiums earned, net investment income and other income, which were partially offset by increases in net loss and LAE, commissions, brokerage and other underwriting expenses, other operating expenses and amortization of intangible assets. Catastrophe losses, net of reinsurance and reinstatement premiums, were $448.7 million in 2012 (including a $412.0 million loss from Sandy), compared with $74.3 million in 2011. Other income in 2012 included a $23.5 million gain from a TransRe legal settlement of a dispute.

Earnings before income taxes for our insurance segment in 2011 decreased from 2010, primarily reflecting higher loss and LAE, lower net premiums earned, lower net investment income, and lower net realized capital gains, partially offset by lower OTTI losses. The increase in loss and LAE primarily reflects a $28.7 million increase in PCC’s prior year reserves and higher catastrophe and other large property losses at RSUI in the 2011 period, partially offset by a higher net release of prior year casualty reserves by RSUI. The decrease in net

 

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premiums earned reflects the impact of continuing competition at CATA, as well as a reduction in net premiums written in certain specialty classes of business by CATA. The decrease in net investment income is due primarily to the impact of negative cash flow at PCC and dividends paid to Alleghany by RSUI and CATA, partially offset by higher dividend income. In addition, the decrease in net investment income in 2011 from 2010 reflects the absence of equity-method partnership income in 2011, as such partnerships were dissolved in the 2010 third quarter.

Reinsurance Segment Underwriting Results

The reinsurance segment is comprised of TransRe’s property and casualty operations. The underwriting results of the reinsurance segment are presented below, commencing on the Acquisition Date. For a more detailed description of our reinsurance segment, see Part I, Item 1, “Business—Segment Information— Reinsurance Segment” of this Form 10-K.

 

     Property     Casualty &  Other(1)     Total  
     (in millions, except ratios)  
Year Ended December 31, 2012                   

Gross premiums written

   $ 966.2      $ 1,974.0      $ 2,940.2   

Net premiums written

     896.9        1,943.8        2,840.7   

Net premiums earned

   $ 900.9      $ 2,015.0      $ 2,915.9   

Net loss and LAE

     566.4        1,491.7        2,058.1   

Commissions, brokerage and other underwriting expenses

     191.1        400.0        591.1   
  

 

 

   

 

 

   

 

 

 

Underwriting profit(2)

   $ 143.4      $ 123.3      $ 266.7   
  

 

 

   

 

 

   

 

 

 

Loss ratio(3)

     62.9     74.0     70.6

Expense ratio(4)

     21.2     19.9     20.3
  

 

 

   

 

 

   

 

 

 

Combined ratio(5)

     84.1     93.9     90.9
  

 

 

   

 

 

   

 

 

 

 

(1) Primarily consists of assumed: D&O liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; surety; and credit.

 

(2) Represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net realized capital gains, OTTI losses, other income, other operating expenses, amortization of intangible assets or interest expense. Underwriting profit is a non-GAAP financial measure and does not replace net earnings determined in accordance with GAAP as a measure of profitability (see “Comment on Non-GAAP Financial Measures”).

 

(3) Net loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.

 

(4) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.

 

(5) The sum of the loss ratio and expense ratio, all as determined in accordance with GAAP, representing the percentage of each premium dollar a reinsurance company has to spend on net loss and LAE, and commission, brokerage and other underwriting expenses.

For both the property and the casualty & other lines of business, the expense ratio for 2012 was favorably impacted as a result of applying the acquisition method of accounting for the merger because deferred acquisition costs were written off at the Acquisition Date. We expect that the expense ratio in subsequent years will increase when all unearned premiums as of the Acquisition Date are fully earned. Excluding the impact of the application of the acquisition method of accounting, the expense ratio for the reinsurance segment was estimated to be approximately 29 percent for 2012.

Property. For 2012, TransRe’s property underwriting profit was $143.4 million, primarily reflecting the favorable impact of the application of the acquisition method of accounting on the expense ratio, partially offset by significant catastrophe losses related to Sandy in October 2012. For 2012, catastrophe losses, net of reinsurance and reinstatement premiums, were $226.9 million, all of which related to Sandy. The $226.9 million is comprised of $252.2 million of net loss and LAE, partially offset by $25.3 million of reinstatement premium. TransRe’s property underwriting profit for 2012 includes $56.6 million of favorable development from prior accident years on loss and LAE reserves acquired.

 

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Casualty & Other. For 2012, TransRe’s casualty & other underwriting profit was $123.3 million, primarily reflecting the favorable impact of the application of the acquisition method of accounting on the expense ratio. For 2012, catastrophe losses, net of reinsurance and reinstatement premiums, were $23.9 million, all of which related to Sandy. The $23.9 million is comprised of $26.2 million of net loss and LAE, partially offset by $2.3 million of reinstatement premium. TransRe’s casualty & other underwriting profit for 2012 includes $31.2 million of favorable development from prior accident years on loss and LAE reserves acquired.

Insurance Segment Underwriting Results

The insurance segment is comprised of AIHL’s RSUI, CATA and PCC operating units. RSUI also writes a modest amount of assumed reinsurance business, which is included in the insurance segment. For a more detailed description of our insurance segment, see Part I, Item 1, “Business—Segment Information—Insurance Segment” of this Form 10-K.

The underwriting results of the insurance segment are presented below.

 

      RSUI     CATA     PCC     Total  
     (in millions, except ratios)  

Year Ended December 31, 2012

        

Gross premiums written

   $ 1,123.4      $ 158.1      $ 19.4      $ 1,300.9   

Net premiums written

     715.1        149.1        19.0        883.2   

Net premiums earned

   $ 655.8      $ 144.6      $ 16.7      $ 817.1   

Net loss and LAE

     466.2        85.9        20.1        572.2   

Commissions, brokerage and other underwriting expenses

     184.3        79.2        27.8        291.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Underwriting profit (loss)(1)

   $ 5.3      $ (20.5   $ (31.2   $ (46.4
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss ratio(2)

     71.1     59.4     120.0     70.0

Expense ratio(3)

     28.1     54.8     166.5     35.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Combined ratio(4)

     99.2     114.2     286.5     105.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Year Ended December 31, 2011

        

Gross premiums written

   $ 986.5      $ 150.4      $ 4.1      $ 1,141.0   

Net premiums written

     627.9        141.6        5.2        774.7   

Net premiums earned

   $ 593.8      $ 149.3      $ 4.5      $ 747.6   

Net loss and LAE

     315.2        83.3        31.5        430.0   

Commissions, brokerage and other underwriting expenses

     170.8        72.7        24.6        268.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Underwriting profit (loss)(1)

   $ 107.8      $ (6.7   $ (51.6   $ 49.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss ratio(2)

     53.1     55.7     701.0     57.5

Expense ratio(3)

     28.8     48.7     547.1     35.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Combined ratio(4)

     81.9     104.4     1,248.1     93.4
  

 

 

   

 

 

   

 

 

   

 

 

 

Year Ended December 31, 2010

        

Gross premiums written

   $ 933.6      $ 168.9      $ 1.5      $ 1,104.0   

Net premiums written

     570.7        159.0        6.5        736.2   

Net premiums earned

   $ 593.6      $ 164.3      $ 10.2      $ 768.1   

Net loss and LAE

     271.0        89.4        17.5        377.9   

Commissions, brokerage and other underwriting expenses

     162.7        73.4        23.2        259.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Underwriting profit (loss)(1)

   $ 159.9      $ 1.5      $ (30.5   $ 130.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss ratio(2)

     45.7     54.4     170.9     49.2

Expense ratio(3)

     27.4     44.7     226.7     33.8
  

 

 

   

 

 

   

 

 

   

 

 

 

Combined ratio(4)

     73.1     99.1     397.6     83.0
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

Represents net premiums earned less net loss and LAE and commissions, brokerage and other underwriting expenses, all as determined in accordance with GAAP, and does not include net investment income, net

 

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  realized capital gains, OTTI losses, other income, other operating expenses, amortization of intangible assets or interest expense. Underwriting profit is a non-GAAP financial measure and does not replace net earnings determined in accordance with GAAP as a measure of profitability (see “Comment on Non-GAAP Financial Measures”).

 

(2) Net loss and LAE divided by net premiums earned, all as determined in accordance with GAAP.

 

(3) Commission, brokerage and other underwriting expenses divided by net premiums earned, all as determined in accordance with GAAP.

 

(4) The sum of the loss ratio and expense ratio, all as determined in accordance with GAAP, representing the percentage of each premium dollar an insurance company has to spend on net loss and LAE, and commission, brokerage and other underwriting expenses.

RSUI. Gross premiums written increased by 13.9 percent in 2012 from 2011, primarily reflecting some improvement in market conditions in all lines of business, particularly property, evidenced by favorable renewal retention rates, strong new business submissions, and mid-single-digit price increases. The increase in net premiums earned in 2012 from 2011 primarily reflects an increase in gross premiums written in recent quarters.

Gross premiums written increased by 5.7 percent in 2011 from 2010, primarily reflecting the impact of assumed premium writings from international insurance carriers, and, to a lesser extent, growth in binding authority business. Such increases were partially offset by the impact of reduced exposures of RSUI’s customers and continuing competition in certain of RSUI’s casualty lines of business. The slight increase in RSUI’s net premiums earned in 2011 from 2010 primarily reflects the impact of a recent increase in gross premiums written starting in the second quarter of 2011, largely offset by the impact of comparatively lower gross premiums written during the third and fourth quarters of 2010 and the first quarter of 2011.

The increase in net loss and LAE in 2012 from 2011 primarily reflects higher catastrophe losses and the impact of an increase in net premiums earned, and, to a lesser extent, slightly lower levels of prior year casualty reserve releases. The increase in loss and LAE in 2011 from 2010 primarily reflects the impact of higher catastrophe and other large property losses, partially offset by the impact of higher releases of prior accident year casualty reserves in 2011.

Catastrophe losses, net of reinsurance and reinstatement premiums, were $197.9 million in 2012, $74.3 million in 2011 and $31.0 million in 2010. Catastrophe losses in 2012 include $161.2 million of net losses, including reinstatement premiums, from Sandy in October 2012. Catastrophe losses in 2012 also include losses from severe weather earlier in 2012, as well as adverse development from prior year catastrophes, including a $9.7 million loss recorded in the second quarter of 2012 related to Hurricane Ike in 2008. Catastrophe losses in 2011 primarily reflect net losses from severe weather, particularly tornados, in the southeastern and midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the East Coast of the United States in August 2011. Catastrophe losses in 2011 also include assumed catastrophe losses from international insurance carriers. In addition, RSUI incurred a $14.4 million property loss arising from the magnitude 5.8 earthquake that occurred in Northern Virginia in August 2011. This earthquake was not classified as a catastrophic event by the property and casualty industry. Catastrophe losses in 2010 include increases in prior accident year property loss reserves of $5.3 million related to 2008 third quarter hurricanes and $11.0 million related to 2005 third quarter hurricanes.

Net loss and LAE for 2012 reflect a $48.1 million release of prior accident year casualty loss reserves during the period, compared with a $56.2 million net release during 2011 and a $33.9 million release during 2010. The $48.1 million release relates primarily to the umbrella/excess liability, general liability, professional liability and D&O liability lines of business primarily for the 2005 through 2008 accident years, and reflects favorable loss emergence compared with claims development patterns assumed in earlier periods for such lines of business. The $56.2 million net release in 2011 relates primarily to the umbrella/excess, general liability and professional liability lines of business, primarily for the 2003 through 2008 accident years, and reflects favorable loss emergence compared with claims development patterns assumed in earlier periods for such lines of business. The 2011 reserve release was partially offset by an increase in loss reserves in the D&O liability line of business in the third quarter of 2011, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year. The $33.9 million release of prior year casualty loss reserves in 2010 primarily reflects favorable loss emergence compared with claims development patterns assumed in earlier periods.

 

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As noted above, there was favorable loss emergence in 2012 compared with loss emergence patterns assumed in earlier periods in many of RSUI’s casualty lines of business. Specifically, cumulative losses for such lines of business, which include both loss payments and case reserves, in respect of prior accident years were expected to be higher through December 31, 2012 than the actual cumulative losses through that date. The amount of lower cumulative losses, expressed as a percentage of carried loss and LAE reserves at the beginning of the year, was 0.2 percent. Such reduction did not impact the assumptions used in estimating RSUI’s loss and LAE liabilities for such lines for business earned in 2012.

The increase in commissions, brokerage and other underwriting expenses in 2012 compared with 2011 is due primarily to the increase in net premiums earned. The increase in commissions, brokerage and other underwriting expenses in 2011 compared with 2010 is due primarily to growth in the binding authority business, which incurs higher commission and other underwriting expenses than other lines of business.

The decrease in RSUI’s underwriting profit in 2012 from 2011 primarily reflects an increase in loss and LAE, partially offset by an increase in net premiums earned. The decrease in RSUI’s underwriting profit in 2011 from 2010 primarily reflects an increase in loss and LAE.

RSUI reinsures its property lines of business through a program consisting of surplus share treaties, facultative placements, per risk coverage, and catastrophe excess of loss treaties. 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 and will expire on April 30, 2013.

Additional information regarding RSUI’s use of reinsurance for its property line of business and risks related to reinsurance recoverables can be found on pages 31 and 32 and pages 41 and 42 of this Form 10-K.

CATA. Gross premiums written increased by 5.1 percent in 2012 from 2011, primarily reflecting growth in CATA’s property and casualty lines of business, and, to a lesser extent, growth in CATA’s surety business. Net premiums earned decreased in the 2012 from 2011 as a result of lower gross premiums written during the third and fourth quarters of 2011 compared with gross premiums written in the third and fourth quarters of 2010.

Gross premiums written decreased by 11.0 percent in 2011 from 2010, primarily reflecting continuing price competition in CATA’s property and casualty lines of business, including in excess and surplus markets, partially offset by higher gross premiums written in CATA’s commercial surety line of business. The decrease in CATA’s property and casualty lines of business also reflects reduced writings associated with certain specialty property and casualty classes of business written through a program administrator in connection with a terminated program, or the “Terminated Program Business.” CATA’s net premiums earned decreased in 2011 from 2010 primarily reflecting the decrease in gross premiums written.

The increase in net loss and LAE in 2012 from 2011 primarily reflects the impact of prior year development. The decrease in loss and LAE in 2011 from 2010 primarily reflects the impact of lower net premiums earned, partially offset by the impact of a net reserve increase of prior accident year loss reserves in 2011 compared with a net reserve release of prior accident year loss reserves in 2010 (as further described below).

Net loss and LAE for 2012 reflect a $13.2 million net increase of prior accident year casualty loss reserves compared with a $5.0 million net increase during 2011 and a $3.9 million net release during 2010. Of the $13.2 million net increase in 2012, $22.2 million relates to the Terminated Program Business in the 2010 and 2009 accident years, partially offset by a net decrease in prior year reserves in certain of CATA’s casualty and surety lines of business. The $13.2 million net reserve increase reflects unfavorable loss emergence compared with claims development patterns assumed in earlier periods for such business. The $5.0 million net reserve increase in 2011 was due primarily to a $14.6 million increase in reserves related to the Terminated Program Business, partially offset by a net reserve release in certain of CATA’s casualty lines of business. The $3.9 million release in 2010 includes $3.5 million reserve release reflecting favorable loss emergence for asbestos-related illnesses and environmental impairment claims that arose from reinsurance assumed by a subsidiary of CATA between 1969 and 1976, based on a reserve study that was completed in the 2010 second quarter.

 

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As noted above, there was unfavorable loss emergence in 2012 compared with claims development patterns assumed in earlier periods associated with CATA’s Terminated Program Business. Specifically, cumulative losses for this business, which include both loss payments and case reserves, in respect of prior accident years were expected to be lower through December 31, 2012 than the actual cumulative losses through that date. The amount of higher cumulative losses, expressed as a percentage of carried loss and LAE reserves at the beginning of the year, was 3.4 percent.

The increase in commissions, brokerage and other underwriting expenses in 2012 compared with 2011 is due primarily to a $5.1 million increase in such expenses due to a change in the accounting rules for deferred acquisition costs.

The increase in CATA’s underwriting loss in 2012 from 2011 primarily reflects an increase in loss and LAE and commissions, brokerage and other underwriting expenses and a decrease in net premiums earned. A decrease in net premiums earned, partially offset by the decrease in loss and LAE, was the primary cause of CATA’s underwriting loss in 2011, compared with an underwriting profit in 2010.

PCC. Commencing August 1, 2009, PCC ceased soliciting new or renewal business on a direct basis due to its determination that it was unable to write business at rates it deemed adequate due to the difficult state of the California workers’ compensation market. After taking steps to transition to being a brokerage carrier, PCC began writing a modest amount of new business through brokers during 2011, which increased in 2012 as market conditions improved. PCC reported underwriting losses of $31.2 million in 2012, $51.6 million in 2011 and $30.5 million in 2010, respectively. The underwriting losses are primarily due to PCC’s ongoing expenses exceeding premiums earned.

For PCC, loss and LAE for 2012 reflect a $5.6 million increase of prior accident year casualty loss and LAE reserves compared with a $28.7 million increase of prior accident year workers’ compensation loss and LAE reserves during 2011 and a $13.4 million reserve increase of prior accident year workers’ compensation loss and LAE reserves during 2010. For 2012, the $5.6 million reserve increase primarily reflects unfavorable loss and LAE emergence compared with loss and LAE development patterns assumed in earlier periods.

The $28.7 million increase of prior accident year workers’ compensation loss and LAE reserves recorded in 2011 include $14.2 million related to an unanticipated increase in medical claims emergence and the absence of anticipated favorable indemnity claims emergence. PCC had anticipated favorable indemnity claims emergence based upon prior claims development experience indicating that injured workers would be returning to work, thereby curtailing lost wage costs. PCC determined that the weak California employment environment had, however, hindered the ability of injured workers to return to work and indirectly influenced indemnity claims. The remaining $14.5 million of the $28.7 million reserve increase related primarily to an increase in LAE reserves arising in part from an increased use of outside counsel to assist in the settlement process, as well as a decrease in ceded loss and LAE reserves based on a review of reinsurance coverage estimates. The review of reinsurance coverage estimates also resulted in a $1.1 million decrease in ceded premiums earned, which increased net premiums earned.

The $13.4 million reserve increase in loss and LAE for 2010 relates primarily to a decrease in ceded loss and LAE reserves based on a fourth quarter 2010 review of reinsurance coverage estimates, which also resulted in a $5.0 million decrease in ceded premiums earned, thereby increasing net premiums earned in 2010, and, to a lesser extent, an increase in unallocated LAE reserves.

The California Department of Insurance, or the “CDI,” is responsible for periodic financial and market conduct examinations of California-domiciled insurance companies. In September 2010, the CDI issued a financial examination report of PCIC for the period from July 1, 2004 through December 31, 2008. As part of its work for such financial examination report, the CDI produced an actuarial report, or the “Actuarial Report,” for the years ended December 31, 2009 and 2008. The Actuarial Report included an estimate of loss and LAE reserves on a statutory basis of accounting that was higher than that recorded by PCIC at such dates. We believed that PCIC’s reserves for unpaid loss and LAE were adequate, and the CDI did not require PCIC to currently or retroactively increase its carried reserves to the estimates included in the Actuarial Report. AIHL did, however,

 

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contribute $40.0 million of capital to PCC on September 27, 2010, and these funds were used by PCIC to increase its workers’ compensation deposit, which PCIC must maintain under California workers’ compensation regulations, to a level consistent with the estimated loss and LAE reserves included in the Actuarial Report. To the extent that PCIC’s actual loss experience is less than the CDI’s final estimate of PCIC’s loss and LAE reserves, over time such additional workers’ compensation deposit funds will be released back to PCIC.

In 2012, we made a $15.0 million capital contribution to PCC.

Total Reinsurance and Insurance Segments Investment Results

Following is information relating to segment investment results (in millions).

 

     Years Ended December 31,  
     2012     2011     2010  

Net investment income

   $ 317.5      $ 117.4      $ 128.9   

Net realized capital gains

     117.9        79.7        92.9   

Other than temporary impairment losses

     (2.9     (3.6     (12.3

Net Investment Income. The increase in net investment income for the reinsurance and insurance segments in 2012 from 2011 is due principally to the impact of including TransRe’s results commencing on the Acquisition Date, partially offset by a decrease in interest income in the insurance segment due to lower prevailing market yields.

The decrease in net investment income in 2011 from 2010 is due principally to the impact of ongoing negative cash flow at PCC and dividends paid by RSUI and CATA to Alleghany, partially offset by higher dividend income. In addition, the decrease in AIHL’s net investment income in 2011 from 2010 reflects the absence of equity-method partnership income in 2011, as such partnerships were dissolved in the 2010 third quarter.

Approximate yields of the reinsurance and insurance segment’s debt securities for 2012, 2011 and 2010 are as follows (in millions, except for percentages):

 

Year

   Average
Investment (1)
     Pre-Tax
Net
Interest
Income (2)
     After-Tax
Net
Interest
Income (3)
     Effective
Yield (4)
    After-Tax
Yield (5)
 

2012

   $ 15,401.3       $ 287.7       $ 251.3         1.9     1.6

2011

     2,649.7         99.0         77.1         3.7     2.9

2010

     2,887.3         102.1         80.2         3.5     2.8

 

(1) Average of amortized cost of debt securities portfolio at beginning and end of period. With respect to the debt securities owned by TransRe, the beginning of the period is the Acquisition Date.

 

(2) After investment expenses and excluding net realized gains and OTTI losses.

 

(3) Pre-tax net interest income less income taxes.

 

(4) Pre-tax net interest income for the period divided by average investments for the same period.

 

(5) After-tax net interest income for the period divided by average investments for the same period.

Net Realized Capital Gains. Net realized capital gains in 2012, 2011 and 2010 relate primarily to sales of equity securities in the energy sector, including a gain from the sale in January 2012 of shares of common stock of Exxon Mobil held at the insurance segment level.

Other Than Temporary Impairment Losses. OTTI losses in 2012 reflect $2.9 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Upon the ultimate disposition of securities for which OTTI losses have been recorded, a portion of the loss may be recoverable depending on market conditions at the time of disposition. Of the $2.9 million incurred during 2012,

 

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$1.7 million related to equity securities, primarily in the energy sector, and $1.2 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the duration of the decline in fair value of such securities relative to their cost as of the balance sheet date.

OTTI losses for 2011 reflect $3.6 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $3.6 million, $3.1 million related to equity security holdings, primarily in the materials and financial services sectors, and $0.5 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity of the declines in fair value of such securities relative to their cost as of the balance sheet date.

OTTI losses for 2010 reflect $12.3 million of unrealized losses that were deemed to be other than temporary and, as such, were required to be charged against earnings. Of the $12.3 million, $11.1 million related to equity security holdings, primarily in the energy sector, and $1.2 million related to debt securities. The determination that unrealized losses on such securities were other than temporary was primarily based on the severity and duration of the declines in fair value of such securities relative to their cost as of the balance sheet date.

After adjusting the cost basis of securities for the recognition of OTTI losses, the remaining gross unrealized investment losses for debt and equity securities as of December 31, 2012 were deemed to be temporary, based on, among other things: (i) the duration of time and the relative magnitude to which fair values of these securities have been below cost were not indicative of an OTTI loss (for example, no equity security was in a continuous unrealized loss position for twelve months or more as of December 31, 2012); (ii) the absence of compelling evidence that would cause us to call into question the financial condition or near-term prospects of the issuers of the securities; and (iii) our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery.

See Note 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on gross unrealized investment losses for debt and equity securities as of December 31, 2012.

Corporate Activities Operating Results

The operating results of corporate activities is presented below (in millions).

 

     Years Ended December 31,  
     2012     2011     2010  

Net premiums earned

   $      $      $   

Net investment income

     (4.5     (8.5     (3.9

Net realized capital gains

     40.0        47.4        4.5   

Other than temporary impairment losses

                     

Gain on bargain purchase

     494.9                 

Other income

     31.2        1.1        6.6   
  

 

 

   

 

 

   

 

 

 

Total revenues

   $ 561.6      $ 40.0      $ 7.2   
  

 

 

   

 

 

   

 

 

 

Net loss and LAE

                     

Commissions, brokerage and other underwriting expenses

                     

Other operating expenses

     34.5        4.9        2.5   

Corporate administration

     75.8        41.0        28.9   

Amortization of intangible assets

                     

Interest expense

     27.6        17.3        5.0   
  

 

 

   

 

 

   

 

 

 

Earnings (loss) before income taxes

   $ 423.7      $ (23.2   $ (29.2
  

 

 

   

 

 

   

 

 

 

Earnings before income taxes in 2012 compared with the loss before income taxes in 2011 primarily reflects the gain on bargain purchase from the merger, partially offset by higher corporate administration expense and higher interest expense. The higher corporate administration expense in 2012 is due primarily to $33.8 million of

 

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Transaction Costs, including $18.0 million payable to our investment bankers, compared with $19.3 million of Transaction Costs incurred in 2011. Corporate administration expense in 2012 also reflects higher compensation and incentive compensation expense due to the impact of the merger on our incentive accruals and changes in staffing at the parent level. Higher interest expense is due to the 2022 Senior Notes (as defined on page 79 of this Form 10-K) which were issued on June 26, 2012. Corporate activities results for 2012 also reflect the impact of our acquisition of BKI on April 26, 2012, including an increase in both other income and other operating expenses. Net realized capital gains in 2012 and 2011 primarily reflect gains from the sale of shares of Exxon Mobil common stock held at the corporate-level in the first quarter of 2012 and the fourth quarter of 2011.

The decrease in losses before income taxes in 2011 from 2010 primarily reflects higher net realized capital gains, partially offset by higher corporate administration and other operating expenses, higher interest expenses, lower other income and higher negative net investment income. Net realized capital gains in 2011 primarily reflects net realized capital gains from the sale of shares of Exxon Mobil common stock held at the corporate-level in the fourth quarter of 2011. The proceeds from such sales were reinvested in short-term securities and cash, and were used to fund Alleghany’s cash consideration in connection with the merger. The higher corporate administration and other operating expenses is due primarily to $19.3 million of Transaction Costs incurred in the 2011 fourth quarter related to the merger, partially offset by lower incentive compensation and pension accruals. The higher interest expenses are due to 2020 Senior Notes (as defined on page 79 of this Form 10-K) which were issued on September 20, 2010. The lower other income in 2011 reflects the absence of a non-recurring gain from Alleghany Properties that existed in 2010. As further explained below, the increase in negative net investment income is due primarily to higher catastrophe losses related to our investment in Homesite, partially offset by higher dividend income and higher interest income. Higher interest income reflects the investment of the proceeds from our Senior Notes and dividends received from subsidiaries.

Net investment income for corporate activities includes our equity share of (losses) earnings in Homesite and ORX, as follows (in millions):

 

     Years Ended December 31,  
     2012     2011     2010  

Homesite

   $ (6.9   $ (20.2   $ (3.2

ORX

     (4.5     (0.7     (2.0

Interest, dividends and other — net

     6.9        12.4        1.3   
  

 

 

   

 

 

   

 

 

 

Net investment income

   $ (4.5   $ (8.5   $ (3.9
  

 

 

   

 

 

   

 

 

 

The Homesite losses in 2012 reflect the impact of increased homeowners insurance claims from severe weather in the second and third quarters of 2012, and $13.2 million of losses representing our share of Homesite’s loss from Sandy in October 2012, partially offset by the favorable impact of higher premium rates. Homesite losses in 2011 primarily reflect the impact of increased homeowners insurance claims from severe weather, particularly tornados, in the southeastern and midwestern U.S. in April and May 2011, as well as from Hurricane Irene, which affected the East Coast of the United States in August 2011. Homesite losses in 2011 also reflect a tax valuation adjustment that Homesite recorded in the fourth quarter of 2011. Homesite losses in 2010 primarily reflect the impact of increased homeowners insurance claims from severe weather and ongoing purchase accounting adjustments.

The lower interest, dividends and other – net in 2012 compared with 2011 primarily reflects significantly lower dividends, partially offset by higher interest income. Lower dividends are due primarily to the sale in January 2012 of shares of Exxon Mobil common stock held at the corporate-level. Higher interest income reflects the investment of proceeds arising from the issuance of Alleghany Senior Notes (as defined on page 82 of this Form 10-K) on June 26, 2012.

Reserve Review Process

Our reinsurance and insurance operating units analyze, at least quarterly, liabilities for unpaid loss and LAE established in prior years 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

 

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estimates of the magnitude of a catastrophe. Adjustments to previously recorded liabilities for unpaid loss and LAE, 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 loss and LAE of our reinsurance and insurance operating units on a gross and net basis by line of business. These reserve amounts represent the accumulation of estimates of ultimate loss (including for IBNR) and LAE.

 

    As of December 31, 2012     As of December 31, 2011     As of December 31, 2010  
    Gross Loss
and LAE
Reserves
    Reinsurance
Recoverables
on Unpaid
Losses
    Net Loss
and LAE
Reserves
    Gross
Loss and
LAE
Reserves
    Reinsurance
Recoverables
on Unpaid
Losses
    Net Loss
and LAE
Reserves
    Gross
Loss and
LAE
Reserves
    Reinsurance
Recoverables
on Unpaid
Losses
    Net Loss
and LAE
Reserves
 
    (in millions)  

Reinsurance Segment

                 

Property

  $ 1,383.9      $ (59.5   $ 1,324.4      $      $      $      $      $      $   

Casualty & other(1)

    8,393.9        (385.5     8,008.4                                             
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    9,777.8        (445.0     9,332.8                                             
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Insurance Segment

                 

Property

    449.9        (186.1     263.8        192.4        (62.3     130.1        150.1        (52.0     98.1   

Casualty(2)

    1,755.6        (654.3     1,101.3        1,844.0        (741.7     1,102.3        1,883.6        (765.2     1,118.4   

Workers’ Compensation

    153.3        (13.0     140.3        167.5        (12.0     155.5        186.7        (10.9     175.8   

All other(3)

    152.1        (63.6     88.5        109.1        (15.8     93.3        108.3        (19.3     89.0   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    2,510.9        (917.0     1,593.9        2,313.0        (831.8     1,481.2        2,328.7        (847.4     1,481.3   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Eliminations

    (48.9     56.1        7.2                                             
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 12,239.8      $ (1,305.9   $ 10,933.9      $ 2,313.0      $ (831.8   $ 1,481.2      $ 2,328.7      $ (847.4   $ 1,481.3   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Primarily consists of assumed: D&O liability; errors and omissions liability; general liability; medical malpractice; ocean marine and aviation; auto liability; accident and health; surety; asbestos-related illnesses and environmental impairment liability; and credit.

 

(2) Primarily consists of direct: umbrella/excess; D&O liability; professional liability; and general liability.

 

(3) Primarily consists of commercial multi-peril, surety and loss and LAE reserves for terminated lines of business and loss reserves acquired in connection with prior acquisitions for which the sellers provided loss reserve guarantees.

Changes in Loss and LAE Reserves between December 31, 2012 and December 31, 2011

Gross and Net Reserves. The significant increase in gross and net loss and LAE reserves as of December 31, 2012 compared with December 31, 2011 is primarily due to reserves acquired as a result of the merger, and, to a lesser extent, the impact of Sandy.

Changes in Loss and LAE Reserves between December 31, 2011 and December 31, 2010

Gross Reserves. Gross loss and LAE reserves as of December 31, 2011 decreased slightly from December 31, 2010, primarily reflecting reserve decreases in the casualty and workers’ compensation lines of business, largely offset by reserve increases in the property lines of business. The decrease in the casualty gross loss and LAE reserves primarily reflects the impact of releases in gross loss and LAE reserves by RSUI during 2011 related to prior accident years, partially offset by the impact of increases in gross loss and LAE reserves by CATA during 2011 related to prior accident years. The decrease in workers’ compensation gross loss and LAE reserves primarily reflects the impact of PCC ceasing to solicit new or renewal business on a direct basis commencing August 1, 2009, partially offset by an increase in gross loss and LAE reserves by PCC related to prior accident years. The increase in property gross loss and LAE reserves is due to increases in case reserves related primarily to significant catastrophe and other large losses incurred in 2011, partially offset by claim payments made by RSUI in 2011 related to catastrophe losses in prior years. Such claim payments caused RSUI to reduce its case reserves from prior accident years, primarily related to 2008 third quarter hurricane losses.

 

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Net Reserves. Net loss and LAE reserves as of December 31, 2011 were essentially unchanged from December 31, 2010, primarily reflecting reserve decreases in the casualty and workers’ compensation lines of business and offsetting reserve increases in the property lines of business. The decrease in the casualty net loss and LAE reserves primarily reflects the impact of releases in net loss and LAE reserves by RSUI during 2011 related to prior accident years, partially offset by the impact of increases in net loss and LAE reserves by CATA during 2011 related to prior accident years. The decrease in workers’ compensation net loss and LAE reserves primarily reflects the impact of PCC ceasing to solicit new or renewal business on a direct basis commencing August 1, 2009, partially offset by an increase in net loss and LAE reserves by PCC related to prior accident years. The increase in property net loss and LAE reserves is due to increases in case reserves related primarily to significant catastrophe and other large losses incurred in 2011, partially offset by claim payments made by RSUI in 2011 related to catastrophe losses in prior years. Such claim payments caused RSUI to reduce its case reserves from prior accident years, primarily related to 2008 third quarter hurricane losses, after reflecting any applicable ceded reinsurance.

Reinsurance Recoverables

As of December 31, 2012, we had total reinsurance recoverables of $1,348.6 million, consisting of $1,305.9 million of ceded outstanding loss and LAE and $42.7 million of recoverables on paid losses. The reinsurance purchased by our reinsurance and insurance operating units does not relieve them from their obligations to their policyholders and cedants, and therefore, the financial strength of their reinsurers is important.

Information regarding concentration of our reinsurance recoverables and the ratings profile of our reinsurers as of December 31, 2012 is as follows (in millions, except percentages):

 

Reinsurer(1)

   Rating(2)    Amount      Percentage  

Swiss Reinsurance Company

   A+ (Superior)    $ 171.4         12.7

American International Group, Inc.

   A (Excellent)      108.3         8.0   

PartnerRe Ltd.

   A+ (Superior)      101.8         7.5   

Syndicates at Lloyd’s of London

   A (Excellent)      95.6         7.1   

Platinum Underwriters Holdings, Ltd.

   A (Excellent)      92.0         6.8   

All other reinsurers

        779.5         57.9   
     

 

 

    

 

 

 

Total reinsurance recoverables(3)

      $ 1,348.6         100.0
     

 

 

    

 

 

 

Secured reinsurance recoverables(4)

      $ 204.6         15.2
     

 

 

    

 

 

 

 

(1) Reinsurance recoverables reflect amounts due from one or more reinsurance subsidiaries of the listed company.

 

(2) Represents the A.M. Best financial strength rating for the applicable reinsurance subsidiary or subsidiaries from which the reinsurance recoverable is due.

 

(3) Approximately 92.5 percent of our reinsurance recoverables balance as of December 31, 2012 was due from reinsurers having an A.M. Best financial strength rating of “A” (Excellent) or higher.

 

(4) Represents reinsurance recoverables secured by funds held, trust agreements and letters of credit.

We had no allowance for uncollectible reinsurance as of December 31, 2012.

Critical Accounting Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that directly affect our reported financial condition and operating performance. More specifically, these estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from reported results to the extent that estimates and assumptions prove to be inaccurate.

 

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We believe our most critical accounting estimates are those with respect to the liability for unpaid loss and LAE reserves, fair value measurements of certain financial assets, OTTI losses on investments, goodwill and other intangible assets, and reinsurance premium revenues, as they require management’s most significant exercise of judgment on both a quantitative and qualitative basis. The accounting estimates that result require the use of assumptions about certain matters that are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, our financial condition, results of operations, and cash flows would be affected, possibly materially.

Unpaid Loss and LAE

Overview. The estimation of the liability for unpaid loss and LAE is inherently difficult and subjective, especially in view of changing legal and economic environments that impact the development of loss reserves, and therefore, quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. In addition, trends that have affected development of liabilities in the past may not necessarily occur or affect liability development to the same degree in the future.

Each of our reinsurance and insurance operating units establishes reserves on its balance sheet for unpaid loss and LAE related to its property and casualty reinsurance and insurance contracts. As of any balance sheet date, there are claims that have not yet been reported, and some claims may not be reported for many years after the date a loss occurs. As a result of this historical pattern, the liability for unpaid loss and LAE includes significant estimates for incurred but not reported, or “IBNR,” claims. Additionally, reported claims are in various stages of the settlement process. Each claim is settled individually based upon its merits, and certain claims may take years to settle, especially if legal action is involved. As a result, the liabilities for unpaid loss and LAE include significant judgments, assumptions and estimates made by management relating to the actual ultimate losses that will arise from the claims. Due to the inherent uncertainties in the process of establishing these liabilities, the actual ultimate loss from a claim is likely to differ, perhaps materially, from the liability initially recorded.

As noted above, as of any balance sheet date, not all claims that have occurred have been reported to us, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled is referred to as the “claim tail.” In general, actuarial judgments for shorter-tailed lines of business generally have much less of an effect on the determination of the loss reserve amount than when those same judgments are made regarding longer-tailed lines of business. Reported losses for the shorter-tailed classes, such as property and certain marine, aviation and energy classes, generally reach the ultimate level of incurred losses in a relatively short period of time. Rather than having to rely on actuarial assumptions for many accident years, these assumptions are generally only relevant for the more recent accident years. Therefore, these assumptions tend to be less critical and the reserves calculated pursuant to these assumptions are subject to less variability for the shorter-tailed lines of business.

For short-tail lines, loss reserves consist primarily of reserves for reported claims. The process of recording quarterly and annual liabilities for unpaid loss and LAE for short-tail lines is primarily focused on maintaining an appropriate reserve level for reported claims and IBNR. Specifically, we assess the reserve adequacy of IBNR in light of such factors as the current levels of reserves for reported claims and expectations with respect to reporting lags, catastrophe events, historical data, legal developments, and economic conditions, including the effects of inflation.

Standard actuarial methodologies employed to estimate ultimate losses incorporate the inherent lag from the time claims occur to when they are reported to an insurer and, if applicable, to when an insurer reports the claims to a reinsurer. Certain actuarial methodologies may be more appropriate than others in instances where this lag may not be consistent from period to period. Consequently, additional actuarial judgment is employed in the selection of methodologies to best incorporate the potential impact of this situation.

Our insurance operating units provide coverage on both a claims-made and occurrence basis. Claims-made policies generally require that claims occur and be reported during the coverage period of the policy. Occurrence policies allow claims which occur during a policy’s coverage period to be reported after the coverage period, and

 

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as a result, these claims can have a very long claim tail, occasionally extending for decades. Casualty claims can have a very long claim tail, in certain situations extending for many years. In addition, casualty claims are more susceptible to litigation and the legal environment and can be significantly affected by changing contract interpretations, all of which contribute to extending the claim tail. For long-tail casualty lines of business, estimating the ultimate liabilities for unpaid loss and LAE is a more complex process and depends on a number of factors, including the line and volume of the business involved. For these reasons, our insurance operating units will generally use actuarial projections in setting reserves for all casualty lines of business.

While the reserving process is difficult for insurance business, the inherent uncertainties of estimating loss reserves are even greater for reinsurance business, due primarily to the longer-tailed nature of much of the reinsurance business, the diversity of development patterns among different types of reinsurance contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which can be subject to change without notice. TransRe writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business for classes such as medical malpractice, D&O liability, errors and omissions liability and general liability. Claims from such classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict.

The estimation of unpaid loss and LAE for our reinsurance operations is principally based on reports and individual case estimates received from ceding companies. Data received from cedants is audited periodically by TransRe’s claims and underwriting personnel, to help ensure that reported data is supported by proper documentation and conforms to contract terms, and is analyzed, as appropriate, by its underwriting and actuarial personnel. Such analysis often includes a detailed review of reported data to assess the underwriting results of assumed reinsurance and to explain any significant departures from expected performance. Over time, reported loss information is ultimately corroborated when the underlying claims are paid.

In addition, the estimation of unpaid loss and LAE, including IBNR, for our reinsurance operations also takes into account assumptions with respect to many factors that will affect ultimate loss costs but are not yet known. The process by which actual carried reserves are determined considers not only actuarial estimates but a myriad of other factors. Such factors, both internal and external, which contribute to the variability and unpredictability of loss costs, include trends relating to jury awards, social trends, medical inflation, worldwide economic conditions, tort reforms, court interpretations of coverages, the regulatory environment, underlying policy pricing, terms and conditions and claims handling, among others. In addition, information gathered through underwriting and claims audits is also considered. We assess the reasonableness of our unpaid loss and LAE for our reinsurance operations using various actuarial methodologies, principally the paid development method, the reported loss development method and the Bornhuetter-Ferguson method as described below.

In conformity with GAAP, our reinsurance and insurance operating units are not permitted to establish reserves for catastrophe losses that have not occurred. Therefore, losses related to a significant catastrophe, or accumulation of catastrophes, in any reporting period could have a material adverse effect on our results of operations and financial condition during that period.

We believe that the reserves for unpaid loss and LAE established by our reinsurance and insurance operating units are adequate as of December 31, 2012; however, additional reserves, which could have a material impact upon our financial condition, results of operations, and cash flows, may be necessary in the future.

Methodologies and Assumptions. Our reinsurance and insurance operating units use a variety of techniques that employ significant judgments and assumptions to establish the liabilities for unpaid loss and LAE recorded at the balance sheet date. These techniques include detailed statistical analyses of past claims reporting, settlement activity, claims frequency, internal loss experience, changes in pricing or coverages and severity data when sufficient information exists to lend statistical credibility to the analyses. More subjective techniques are used when statistical data is insufficient or unavailable. These liabilities also reflect implicit or explicit assumptions regarding the potential effects of future inflation, judicial decisions, changes in laws and recent trends in such factors, as well as a number of actuarial assumptions that vary across our reinsurance and insurance operating units and across lines of business. This data is analyzed by line of business, coverage, accident year or underwriting year and reinsurance contract type, as appropriate.

 

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Our loss reserve review processes use actuarial methods that vary by operating unit and line of business and produce point estimates for each class of business. The actuarial methods used include the following methods:

 

   

Reported Loss Development Method: a reported loss development pattern is calculated based on historical loss development data, and this pattern is then used to project the latest evaluation of cumulative reported losses for each accident year or underwriting year, as appropriate, to ultimate levels;

 

   

Paid Development Method: a paid loss development pattern is calculated based on historical paid loss development data, and this pattern is then used to project the latest evaluation of cumulative paid losses for each accident year or underwriting year, as appropriate, to ultimate levels;

 

   

Expected Loss Ratio Method: expected loss ratios are applied to premiums earned, based on historical company experience, or historical insurance industry results when company experience is deemed not to be sufficient; and

 

   

Bornhuetter-Ferguson Method: the results from the Expected Loss Ratio Method are essentially blended with either the Reported Loss Development Method or the Paid Development Method.

The primary actuarial assumptions used by our reinsurance and insurance operating units include the following:

 

   

Expected loss ratios represent management’s expectation of losses, in relation to earned premium, at the time business is written, before any actual claims experience has emerged. This expectation is a significant determinant of the estimate of loss reserves for recently written business where there is little paid or incurred loss data to consider. Expected loss ratios are generally derived from historical loss ratios adjusted for the impact of rate changes, loss cost trends and known changes in the type of risks underwritten. For certain longer-tailed reinsurance business that are typically lower frequency, high severity classes, expected loss ratios are often used for the last several accident years or underwriting years, as appropriate.

 

   

Rate of loss cost inflation (or deflation) represents management’s expectation of the inflation associated with the costs we may incur in the future to settle claims. Expected loss cost inflation is particularly important for longer-tailed classes.

 

   

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 operating units, modified for current trends. These emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value.

In the absence of sufficiently credible internally-derived historical information, each of the above actuarial assumptions may also incorporate data from the insurance or reinsurance industries as a whole, or peer companies writing substantially similar coverages. Data from external sources may be used to set expectations, as well as assumptions regarding loss frequency or severity relative to an exposure unit or claim, among other actuarial parameters. Assumptions regarding the application or composition of peer group or industry reserving parameters require substantial judgment.

Loss Frequency and Severity. Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described above. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs and changes in economic conditions or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to our reinsurance or insurance operating unit. The length of the loss reporting lag affects their ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags), as well as the amount of reserves needed for IBNR. If the actual level of loss frequency and severity is higher or lower than expected, the ultimate losses will be different than management’s estimates. A small percentage change in an estimate can

 

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result in a material effect on our reported earnings. The following table reflects the impact of changes, which could be favorable or unfavorable, in frequency and severity on our loss estimates for claims occurring in 2012 (in millions):

 

     Frequency  

Severity

   1.0%      5.0%      10.0%  

1.0%

   $ 53.1       $ 159.9       $ 293.3   

5.0%

     159.9         270.9         409.6   

10.0%

     293.3         409.6         554.9   

Our net reserves for loss and LAE of $10.9 billion as of December 31, 2012 relate to multiple accident years. Therefore, the impact of changes in frequency or severity for more than one accident year could be higher or lower than the amounts reflected above. We believe the above analysis provides a reasonable benchmark for sensitivity as we believe it is within historical variation for our reserves. Currently, none of the scenarios is believed to be more likely than the other. See Note 1(k) and Note 6 to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our loss and LAE.

Prior Year Development. Our reinsurance and insurance operating units continually evaluate the potential for changes, both positive and negative, in their estimates of their loss and LAE liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid loss and LAE 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 loss and LAE, 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. We adjusted our prior year loss and LAE reserve estimates during 2012 and 2011 based on current information that differed from previous assumptions made at the time such loss and LAE reserves were previously estimated. These reserve (decreases) increases to prior year net reserves are summarized as follows (in millions):

 

     2012     2011  

Reinsurance:

    

Property reserve releases

   $      $   

Casualty & other reserve releases

              
  

 

 

   

 

 

 
              
  

 

 

   

 

 

 

Insurance:

    

RSUI

    

Net casualty reserve releases

     (48.1     (56.2

Property and other, net

     17.0        (3.3
  

 

 

   

 

 

 
     (31.1     (59.5
  

 

 

   

 

 

 

CATA

     13.2        5.0   

PCC

     5.6        28.7   
  

 

 

   

 

 

 

Total incurred related to prior years

   $ (12.3   $ (25.8
  

 

 

   

 

 

 

The more significant prior year adjustments affecting 2012 and 2011 are summarized as follows:

 

   

For RSUI, loss and LAE reflect a $48.1 million release of prior accident year casualty loss reserves during 2012, compared with a $56.2 million net release during 2011. The $48.1 million release relates primarily to the umbrella/excess liability, general liability, professional liability lines and D&O liability of business primarily for the 2005 through 2008 accident years, and reflects favorable loss emergence compared with claims development patterns assumed in earlier periods for such lines of business. The $56.2 million net release in 2011 relates primarily to the umbrella/excess, general

 

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liability and professional liability lines of business, primarily for the 2003 through 2008 accident years, and reflects favorable loss emergence compared with claims development patterns assumed in earlier periods for such lines of business. The 2011 reserve release was partially offset by an increase in the D&O liability line of business in the 2011 third quarter, primarily reflecting adverse legal developments associated with a large claim from the 2007 accident year.

As noted above, there was favorable loss emergence in 2012 compared with loss emergence patterns assumed in earlier periods in many of RSUI’s casualty lines of business. Specifically, cumulative losses for such lines of business, which include both loss payments and case reserves, in respect of prior accident years were expected to be higher through December 31, 2012 than the actual cumulative losses through that date. The amount of lower cumulative losses, expressed as a percentage of carried loss and LAE reserves at the beginning of the year, was 0.2 percent. Such reduction did not impact the assumptions used in estimating RSUI’s loss and LAE liabilities for such lines for business earned in 2012.

 

   

For RSUI, loss and LAE for 2012 and 2011 also include a $17.0 million increase and a $3.3 million net release of prior accident year loss reserves, respectively, primarily related to a re-estimation of case and IBNR reserves in the property line of business. For 2012, the $17.0 million reserve increase includes a $9.7 million loss recorded in the second quarter of 2012 related to Hurricane Ike in 2008. For 2011, the $3.3 million net reserve release primarily reflects significant reserve releases in non-catastrophe property reserves and unallocated LAE, partially offset by reserve increases related to prior year catastrophes.

 

   

For CATA, loss and LAE for 2012 reflect a $13.2 million net increase of prior accident year loss reserves during the period, compared with a $5.0 million net increase of prior accident year loss reserves during 2011. Of the $13.2 million net increase in 2012, $22.2 million relates to certain specialty property and casualty classes of business through the Terminated Program Business in the 2010 and 2009 accident years, partially offset by a net decrease in prior year reserves in certain of CATA’s casualty and surety lines of business. The $13.2 million net reserve increase reflects unfavorable loss emergence compared with loss emergence patterns assumed in earlier periods for such business. The $13.2 million net increase of prior accident year loss reserves did not impact the assumptions used in estimating CATA’s loss and LAE liabilities for business earned in 2012.

The $5.0 million net reserve increase in 2011 consists of a $14.6 million increase in reserves related to the Terminated Program Business, partially offset by a net reserve release in certain of CATA’s casualty lines of business. The reserve increase in the Terminated Program Business reflects unfavorable loss emergence, primarily in the 2009 and 2010 accident years, compared with claims development patterns assumed in earlier periods for such business.

 

   

For PCC, loss and LAE for 2012 reflect a $5.6 million increase of prior accident year workers’ compensation net loss and LAE reserves compared with a $28.7 million reserve increase of prior accident year workers’ compensation loss and LAE reserves during 2011. For 2012, the $5.6 million reserve increase primarily reflects unfavorable loss and LAE emergence compared with loss and LAE development patterns assumed in earlier periods.

The $28.7 million increase of prior accident year workers’ compensation loss reserves and LAE recorded in 2011 include $14.2 million related to an unanticipated increase in medical claims emergence and the absence of anticipated favorable indemnity claims emergence. PCC had anticipated favorable indemnity claims emergence based upon prior claims development experience indicating that injured workers would be returning to work, thereby curtailing lost wage costs. PCC determined that the weak California employment environment had, however, hindered the ability of injured workers to return to work and indirectly influenced indemnity claims. The remaining $14.5 million of the $28.7 million increase related primarily to an increase in LAE reserves arising in part from an increased use of outside counsel to assist in the settlement process, as well as a decrease in ceded loss and LAE reserves based on a review of reinsurance coverage estimates. The review of reinsurance coverage estimates also resulted in a $1.1 million decrease in ceded premiums earned, which increased net premiums earned.

 

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Asbestos and Environmental Impairment Reserves. Loss and LAE include amounts for risks relating to asbestos-related illnesses and environmental impairment. The reserves carried for such claims, including the IBNR portion, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for asbestos-related illnesses and environmental impairment losses, particularly for those occurring in 1985 and prior, which represents the majority of TransRe’s asbestos-related illness and environmental impairment reserves. This uncertainty is due to inconsistent and changing court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other reasons. Further, possible future changes in statutes, laws, regulations, theories of liability and other factors could have a material effect on these liabilities and, accordingly, future earnings. Although we are unable at this time to determine whether additional reserves, which could have a material adverse effect upon our results of operations, may be necessary in the future, we believe that our asbestos-related illnesses and environmental impairment reserves are adequate as of December 31, 2012. See Note 12(d) to Notes to Consolidated Financial Statements set forth in Part II, Item 8 and pages 29 and 30 of this Form 10-K for additional information on loss and LAE for risks relating to asbestos-related illnesses and environmental impairment.

Reinsurance. Our reinsurance and insurance operating units reinsure portions of the risks they underwrite in order to reduce the effect of individual or aggregate exposure to losses, manage capacity, protect capital resources, reduce volatility in specific lines, improve risk-adjusted portfolio returns and enable them to increase gross premium writings and risk capacity for other business without requiring additional capital. If the assuming reinsurers are unable or unwilling to meet the obligations assumed under the applicable reinsurance agreements, our reinsurance and insurance operating units would remain liable for such amounts not paid by their reinsurers. Recoverables recorded with respect to claims ceded to reinsurers under reinsurance contracts are predicated in large part on the estimates for unpaid losses and, therefore, are also subject to a significant degree of uncertainty. In addition to the factors cited above, reinsurance recoverables may prove uncollectible if a reinsurer is unable or unwilling to perform under a contract. Reinsurance purchased by our reinsurance and insurance operating units does not relieve them of their obligations to their own policyholders or cedants. Additional information regarding the use of, and risks related to, the use of reinsurance by our reinsurance and insurance operating units can be found on pages 31 and 32 and pages 41 and 42 of this Form 10-K. Also see Note 1(f) and Note 5 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our reinsurance recoverables.

Fair Value Measurement of Certain Financial Assets

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing, able and knowledgeable market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, a three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs are the reporting entity’s own assumptions about market participant assumptions based on the best information available under the circumstances. In assessing the appropriateness of using observable inputs in making fair value determinations, we consider whether the market for a particular security is “active” or not based on all the relevant facts and circumstances. A market may be considered to be inactive if there are relatively few recent transactions or if there is a significant decrease in market volume. Furthermore, we consider whether observable transactions are “orderly” or not. We do not consider a transaction to be orderly if there is evidence of a forced liquidation or other distressed condition, and as such, little or no weight is given to that transaction as an indicator of fair value.

A three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Assets classified as Level 3 principally include certain residential mortgage-backed securities, or “RMBS,” commercial mortgage-backed securities, or “CMBS,” other asset-backed securities and partnership investments. The valuation of Level 3 assets requires the greatest degree of judgment, as these valuations are based on techniques that use significant inputs that are unobservable. These

 

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measurements may be made under circumstances in which there is little, if any, market activity for the asset. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, we consider factors specific to the asset. Some Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained.

Mortgage and asset-backed securities are initially valued at the transaction price. Subsequently, we use widely accepted valuation practices that produce a fair value measurement by comparison to transactions in similarly structured instruments, use of discounted cash flows, or option adjusted spread analyses. Unobservable inputs, significant to the measurement and valuation of mortgage and asset-backed securities, include assumptions about prepayment speed and collateral performance, including default, delinquency and loss severity rates. Significant changes to any one of these inputs, or combination of inputs, could significantly change the fair value measurement for these securities.

Fair values for partnership and private equity investments are initially valued at the transaction price. Subsequently, fair value is based on the performance of the portfolio of investments or results of operations of the investee. Significant improvements or disruptions in the financial markets may result in directionally similar or opposite changes to the portfolio of the investee, depending on how management of the investee has correlated the portfolio of investments to the market. Also, any changes made by the investee to the investment strategy of the private equity investment could result in significant changes to fair value that have a positive or negative correlation to the performance observed in the equity markets. For those investments whose performance is based on the results of operations within a specific industry, significant events impacting that industry could materially impact fair value. Also, decisions and changes to strategy made by management of the investee could result in positive or negative outcomes, which could significantly impact the results of operations of the investee and subsequently fair value.

See Notes 1(b), 1(c), 3 and 4 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our investments and fair value.

Investment Impairment

The determination that an investment has incurred an OTTI loss in value requires the judgment of management and consideration of the fundamental condition of the issuer, its near-term prospects and all the relevant facts and circumstances.

We hold our equity and debt securities as available-for-sale, or “AFS,” 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. The analysis of any individual security’s decline in value is performed in its functional currency. If the decline of a particular investment is deemed temporary, we record the decline as an unrealized loss in stockholders’ equity. If the decline is deemed to be other than temporary, we write our cost- or amortized cost-basis down to the fair value of the investment and record an OTTI loss on our statement of earnings. In addition, any portion of such decline that relates to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income, rather than charged against earnings.

Management’s assessment of equity securities initially involves an evaluation of all securities that are in an unrealized loss position, regardless of the duration or severity of the loss, as of the applicable balance sheet date. Such initial review consists primarily of assessing whether: (i) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; and (ii) we have the ability and intent to hold an equity security for a period of time sufficient to allow for an anticipated recovery (generally considered to be less than one year from the balance sheet date).

To the extent that an equity security in an unrealized loss position is not impaired based on the initial review described above, we then further evaluate such equity security and deem it to be other than temporarily impaired if it has been in an unrealized loss position for twelve months or more or if its unrealized loss position is greater than 50 percent of its cost, absent compelling evidence to the contrary.

 

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We then evaluate those equity securities where the unrealized loss is 20 percent or more of cost as of the balance sheet date or which have been in an unrealized loss position continuously for six months or more preceding the balance sheet date. This evaluation takes into account quantitative and qualitative factors in determining whether such securities are other than temporarily impaired including: (i) market valuation metrics associated with the equity security such as dividend yield and price-to-earnings ratio; (ii) current views on the equity security, as expressed by either our internal stock analysts and/or by third party stock analysts or rating agencies; and (iii) discrete credit or news events associated with a specific company, such as negative news releases and rating agency downgrades with respect to the issuer of the investment.

Debt securities in an unrealized loss position are evaluated for OTTI if they meet any of the following criteria: (i) they are trading at a 20 percent discount to amortized cost for an extended period of time (nine consecutive months or longer); (ii) there has been a negative credit or news event with respect to the issuer that could indicate the existence of an OTTI; and (iii) we intend to sell or it is more likely than not that we will sell the debt security before recovery of its amortized cost basis.

If we intend to sell or it is more likely than not that we will sell a debt security before recovery of its amortized cost basis, the total amount of the unrealized loss position is recognized as an OTTI loss in earnings. To the extent that a debt security that is in an unrealized loss position is not impaired based on the preceding, we will consider a debt security to be impaired when we believe it to be probable that we will not be able to collect the entire amortized cost basis. For debt securities in an unrealized loss position as of the end of each quarter, we develop a best estimate of the present value of expected cash flows. If the results of the cash flow analysis indicate we will not recover the full amount of its amortized cost basis in the security, we record an OTTI loss in earnings equal to the difference between the present value of expected cash flows and the amortized cost basis of the security. If applicable, the difference between the total unrealized loss position on the security and the OTTI loss recognized in earnings is the non-credit related portion and is recorded as a component of other comprehensive income.

In developing the cash flow analyses for debt securities, we consider various factors for the different categories of debt securities. For municipal bonds, we take into account the taxing power of the issuer, source of revenue, credit risk and credit enhancements and pre-refunding. For mortgage and asset-backed securities, we discount our best estimate of future cash flows at an effective rate equal to the original effective yield of the security or, in the case of floating rate securities, at the current coupon. Our models include our assumptions about prepayment speeds, default and delinquency rates, and underlying collateral (if any), as well as credit ratings, credit enhancements and other observable market data. For corporate bonds, we review business prospects, credit ratings and available information from asset managers and rating agencies for individual securities.

We may ultimately record a realized loss after having originally concluded that a 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 assumptions about financial condition, liquidity or future prospects, inadequacy of any underlying collateral, and unfavorable changes in economic conditions or social trends, interest rates or credit ratings.

See Note 1(b) and Note 4(e) to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our investments and investment impairments.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets, net of amortization, are recorded as a consequence of business acquisitions. Goodwill represents the excess, if any, of the amount paid to acquire subsidiaries and other businesses over the fair value of their net assets at the date of acquisition. Other intangible assets are recorded at their fair value as of the acquisition date. A significant amount of judgment is needed to determine the fair values at the date of acquisition of other intangible assets and the net assets acquired in a business acquisition. The determination of the fair value of other intangible assets and net assets often involves the use of valuation models and other estimates, which involve many assumptions and variables and are inherently subjective. Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. Goodwill and intangible assets that have an indefinite useful life are not subject to amortization.

 

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Goodwill and other intangible assets deemed to have an indefinite useful life are tested annually in the fourth quarter of every year for impairment. Goodwill and other intangible assets are also tested whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. A significant amount of judgment is required in performing goodwill and other intangible asset impairment tests. These tests may include estimating the fair value of our operating units and other intangible assets. If it is determined that an asset has been impaired, the asset is written down by the amount of the impairment, with a corresponding charge to net earnings. Subsequent reversal of any impairment charge is not permitted.

With respect to goodwill, a qualitative assessment is first made to determine whether it is necessary to perform quantitative testing. This initial assessment includes, among others, consideration of: (i) past, current and projected future earnings and equity; (ii) recent trends and market conditions; and (iii) valuation metrics involving similar companies that are publicly-traded and acquisitions of similar companies, if available. If this initial qualitative assessment indicates that the fair value of an operating unit of ours may be less than its respective carrying amount, a second step is taken, involving a comparison between the estimated fair values of our operating units with their respective carrying amounts including goodwill. Under GAAP, fair value refers to the amount for which the entire operating unit may be bought or sold. The methods for estimating operating unit values include asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. All of these methods involve significant estimates and assumptions. If the carrying value exceeds estimated fair value, there is an indication of potential impairment, and a third step is performed to measure the amount of impairment. The third step involves calculating an implied fair value of goodwill by measuring the excess of the estimated fair value of the operating units over the aggregate estimated fair values of the individual assets less liabilities. If the carrying value of goodwill exceeds the implied fair value of goodwill, an impairment charge is recorded for the excess.

Our consolidated balance sheet as of December 31, 2012 includes goodwill of $83.4 million related to RSUI, CATA and BKI, and intangible assets, net of amortization, of $128.8 million related to TransRe, RSUI, CATA and BKI. See Note 1(i), Note 1(q) and Note 2 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional information on our goodwill and other intangible assets.

Reinsurance Premium Revenues

We must make certain judgments in the determination of assumed reinsurance premiums written and earned. For pro rata contracts, premiums written and earned are generally based on reports received from ceding companies. For excess-of-loss contracts, premiums are generally recorded as written based on contract terms and are earned ratably over the periods the related coverages are provided. Unearned premiums and ceded unearned premiums represent the portion of gross premiums written and ceded premiums written, respectively, relating to the unexpired periods of such coverages. The relationship between net premiums written and net premiums earned will, therefore, generally vary depending on the volume and inception dates of the business assumed and ceded and the mix of such business between pro rata and excess-of-loss reinsurance.

Premiums written and earned, along with related costs, for which data have not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. Such estimates of premiums earned are considered when establishing the IBNR portion of loss reserves. The differences between these estimates and actual data subsequently reported, which may be material as a result of the diversity of cedants and reporting practices and the inherent difficulty in estimating premium inflows, among other factors, are recorded in the period when actual data become available and such differences may materially affect our results of operations.

In addition to the policies described above which contain critical accounting estimates, our other accounting policies are described in Note 1 to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K. The accounting policies described in Note 1 require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities that do not meet the level of materiality required for a determination that the accounting policy includes critical accounting estimates. On an ongoing basis, we evaluate our estimates, including those related to the value of deferred acquisition costs, incentive compensation, income taxes, pension benefits and contingencies and

 

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litigation. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our actual results may differ from these estimates under different assumptions or conditions.

Financial Condition

Parent Level

General. In general, we follow a policy of maintaining a relatively liquid financial condition at the parent company. This policy has permitted us to expand our operations through internal growth at our subsidiaries and through acquisitions of, or substantial investments in, operating companies. As of December 31, 2012, we held total marketable securities and cash of $731.7 million, compared with $1,234.9 million as of December 31, 2011. The decrease during 2012 primarily reflects the payment of the $816.0 million cash portion of our purchase price for TransRe, partially offset by $396.0 million of proceeds from the issuance of the Alleghany Senior Notes (discussed below). The $731.7 million is comprised of $463.5 million at the parent company, $90.0 million at AIHL and $178.2 million at the TransRe holding company level. We believe that we have and will have adequate internally generated funds, cash resources and unused credit facilities to provide for the currently foreseeable needs of our business, and we had no material commitments for capital expenditures as of December 31, 2012.

Stockholders’ equity was approximately $6.4 billion as of December 31, 2012, compared with approximately $2.9 billion as of December 31, 2011. The increase in stockholders’ equity primarily reflects $2.7 billion from 8,360,959 shares issued pursuant to the merger and 2012 net earnings, including the gain on bargain purchase. As of December 31, 2012, we had 16,890,623 shares of our common stock outstanding, compared with 8,551,646 shares of our common stock outstanding as of December 31, 2011.

Debt. On June 26, 2012, we completed a public offering of $400.0 million aggregate principal amount of our 4.95% senior notes due on June 27, 2022, or the “2022 Senior Notes.” The 2022 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest is payable semi-annually on June 27 and December 27 of each year. The terms of the 2022 Senior Notes permit redemption prior to their maturity. The indenture under which the 2022 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2022 Senior Notes were issued at approximately 99.9 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $396.0 million, and an effective yield of approximately 5.05 percent. Approximately $3.6 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2022 Senior Notes.

On September 20, 2010, we completed a public offering of $300.0 million aggregate principal amount of our 5.625% senior notes due on September 15, 2020, or the “2020 Senior Notes.” The 2020 Senior Notes are unsecured and unsubordinated general obligations of Alleghany. Interest is payable semi-annually on March 15 and September 15 of each year. The terms of the 2020 Senior Notes permit redemption prior to their maturity. The indenture under which the 2020 Senior Notes were issued contains covenants that impose conditions on our ability to create liens on, or engage in sales of, the capital stock of AIHL, TransRe or RSUI. The 2020 Senior Notes were issued at approximately 99.6 percent of par, resulting in proceeds after underwriting discount, commissions and other expenses of $298.9 million, and an effective yield of approximately 5.67 percent. Approximately $2.8 million of underwriting discount, commissions and other expenses were recorded as deferred charges, which are amortized over the life of the 2020 Senior Notes.

Credit Agreement. On September 9, 2010, we entered into a three-year credit agreement, or the “Credit Agreement,” with a bank syndicate, providing commitments, the “Commitments,” for a two tranche revolving credit facility in an aggregate principal amount of up to $100.0 million, consisting of (i) a secured credit facility, or “Tranche A,” subject to a borrowing base as set forth in the Credit Agreement, in an aggregate principal amount of up to $50.0 million, and (ii) an unsecured credit facility, or “Tranche B,” in an aggregate principal amount of up to $50.0 million. The Commitments under the Credit Agreement are scheduled to terminate on September 9, 2013, or the “Maturity Date,” unless terminated earlier. Borrowings under the Credit Agreement are available for working capital and general corporate purposes.

 

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Alternate Base Rate Borrowings under the Credit Agreement bear interest at (x) the greatest of (a) the administrative agent’s prime rate, (b) the federal funds rate plus 0.5 percent or (c) an adjusted London Interbank Overnight, or “LIBO,” rate for a one month interest period on such day plus 1 percent, plus (y) a specified margin (currently 0 basis points for Tranche A and 125 basis points for Tranche B). Eurodollar Borrowings under the Credit Agreement bear interest at an adjusted LIBO Rate for the interest period in effect plus a specified margin (currently 75 basis points for Tranche A and 225 basis points for Tranche B). The Credit Agreement requires that all loans be repaid in full no later than the Maturity Date. The Credit Agreement also requires us to pay a commitment fee each quarter in a range of between one fifth and one-half of one percent per annum, in each case based upon our credit ratings, on the daily unused amount of the Commitments of the relevant Tranche.

The Credit Agreement contains representations, warranties and covenants customary for bank loan facilities of this nature. In this regard, the Credit Agreement requires us to, among other things, (i) maintain a consolidated net worth of not less than the sum of (x) approximately $2.0 billion plus (y) 50 percent of Alleghany’s accumulated, consolidated net earnings earned in each fiscal quarter (if positive) commencing September 30, 2010 and (ii) maintain a ratio of total indebtedness to total capital as of the end of each fiscal quarter of not greater than 0.25 to 1.0. Additionally, the Credit Agreement contains various negative covenants with which we must comply, including, but not limited to, limitations respecting the creation of liens on any property or asset; the incurrence of indebtedness; mergers, consolidations, liquidations and dissolutions; change of business; sales of assets; transactions with affiliates; and other provisions customary in similar types of agreements. In addition, at any time when a default has occurred and is continuing or would result therefrom, the Credit Agreement proscribes our ability to declare or pay, or permit certain of our subsidiaries to declare or pay, any dividend on, or make any payment on account of, or set apart assets for a sinking or other analogous fund for, the purchase, redemption, defeasance, retirement or acquisition of, any of our stock or any such subsidiaries.

If an Event of Default occurs under the Credit Agreement, then, to the extent permitted in the Credit Agreement, the Lenders may, as applicable, terminate the Commitments, accelerate the repayment of any outstanding loans and exercise all rights and remedies available to such Lenders under the Credit Agreement, the Security Agreement and related documents and applicable law, including, without limitation, exercising rights and remedies with respect to the collateral for the benefit of the Tranche A Lenders. In the case of an Event of Default that exists due to the occurrence of certain involuntary or voluntary bankruptcy, insolvency or reorganization events relating to us, the Commitments will automatically terminate and the repayment of any outstanding loans shall be automatically accelerated.

The Security Agreement secures all of our obligations relating to the Tranche A Loans under the Credit Agreement, and grants to a collateral agent for the Lenders, or “Collateral Agent,” a continuing first priority lien on and security interest in, and assigns to the Collateral Agent (for the ratable benefit of the Lenders) as collateral security, all of our right, title and interest in and to: (i) all cash, securities, shares of stock, investment property, financial assets, equity interests, instruments and general intangibles which are from time to time held in or credited to a certain account, or the “Account,” maintained with the Collateral Agent, (ii) the Account itself, and (iii) all rights to which we now or hereafter become entitled by reason of our interest in any of the previously described collateral, and all security entitlements related to the Account and the financial assets credited to the Account, and the additions to, accessions to, substitutions of, products or proceeds of any or all of the foregoing.

There were no borrowings under the Credit Agreement since its inception through December 31, 2012.

Dividends from Subsidiaries. As of December 31, 2012, approximately $610.4 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 $5.9 billion of our total equity of $6.4 billion was unavailable for dividends or advances to us from our subsidiaries.

Our reinsurance and insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid by them without prior approval of the relevant regulatory authorities. These limitations have not affected our ability to meet our obligations.

With respect to TransRe, its operating subsidiaries could ordinarily pay dividends without regulatory approval based on statutory surplus. However, for a period of 24 months following the Acquisition Date, TRC is

 

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prohibited from paying a dividend to TransRe in excess of $200.0 million in the aggregate in any given 12 month period without the prior approval of the New York State Department of Financial Services. From the Acquisition Date through December 31, 2012, TRC paid dividends of $100.0 million to TransRe.

With respect to AIHL, its operating subsidiaries could also pay additional dividends without regulatory approval based on statutory surplus. Of the aggregate total equity of our insurance operating units as of December 31, 2012 of $1.9 billion, a maximum of $127.4 million was available for dividends without prior approval of the applicable insurance regulatory authorities. In 2012, CATA paid AIHL a cash dividend of $15.0 million. In 2011, RSUI paid AIHL a cash dividend of $100.0 million and CATA paid AIHL a cash dividend of $15.0 million. In 2010, RSUI paid AIHL a cash dividend of $100.0 million and CATA paid AIHL a cash dividend of $25.0 million.

Common Stock Repurchases. In July 2010, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management may determine advisable, up to an aggregate of $300.0 million. Such share repurchase program was terminated upon the entry in November 2011 into the Merger Agreement with Old TransRe. In October 2012, our Board of Directors authorized the repurchase of shares of our common stock, at such times and at prices as management determines advisable, up to an aggregate of $300.0 million.

In December 2012, we repurchased an aggregate of 53,346 shares of our common stock in the open market for $17.8 million, at an average price per share of $333.08. During 2011, we repurchased an aggregate of 399,568 shares of our common stock in the open market for $120.3 million, at an average price per share of $301.14. During 2010, we repurchased an aggregate of 285,056 shares of our common stock in the open market for $83.1 million, at an average price per share of $291.64. All of the foregoing per share and average price data has not been adjusted for subsequent Alleghany common stock dividends.

Dividends. We have declared stock dividends in lieu of cash dividends every year since 1987 except 1998, when our wholly-owned subsidiary, Chicago Title Corporation, was spun off to our stockholders and 2012. In light of the merger, our board of directors determined not to declare a stock dividend for 2012.

Capital Contributions. From time to time, we make capital contributions to our subsidiaries. In 2012, we made a $15.0 million capital contribution to PCC to provide additional capital support. In 2010, we made a capital contribution of $40.0 million to provide capital support to PCIC in connection with an increase in its workers’ compensation deposit, which PCIC must maintain under California workers’ compensation regulations. In 2007, we made a capital contribution of $50.0 million to provide additional capital support to PCC in connection with AIHL’s acquisition of PCC. We expect that we will continue to make capital contributions to our subsidiaries from time to time in the future for similar or other purposes.

Contractual Obligations. We have certain obligations to make future payments under contracts and credit-related financial instruments and commitments. As of December 31, 2012, certain long-term aggregate contractual obligations and credit-related financial commitments were as follows (in millions):

 

Contractual Obligations

   Total      Within
1 Year
     More than
1 Year
but Within
3 Years
     More than
3 Years
but Within
5 Years
     More than
5 years
 

Loss and LAE

   $ 12,239.8       $ 2,968.6       $ 3,744.8       $ 1,997.9       $ 3,528.5   

Senior Notes and related interest(1)

     2,909.8         103.0         873.0         129.4         1,804.4   

Operating lease obligations

     283.7         27.8         58.3         46.3         151.3   

Investments(2)

     40.2         26.0         7.1         7.1         —     

Other long-term liabilities(3)

     257.6         91.7         72.9         19.1         73.9   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 15,731.1       $ 3,217.1       $ 4,756.1       $ 2,199.8       $ 5,558.1   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

“Senior Notes” refers to: (i) the “TransRe Senior Notes,” which consist of TransRe’s 5.75% senior notes due on December 14, 2015, or the “2015 Notes,” and the 8.00% senior notes due on November 30, 2039, or

 

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  the “2039 Notes;” and (ii) the “Alleghany Senior Notes,” which consist of the 2020 Senior Notes and the 2022 Senior Notes. See Note 8 to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for further details on the Senior Notes.

 

(2) Primarily reflect capital commitments to investment partnerships.

 

(3) Primarily reflect employee pension obligations, certain retired executive pension obligations and obligations under certain incentive compensation plans.

Our reinsurance and insurance operating units have obligations to make certain payments for loss and LAE pursuant to insurance policies and reinsurance contracts they issue. These future payments are reflected as reserves on our consolidated financial statements. With respect to loss and LAE, there is typically no minimum contractual commitment associated with insurance policies and reinsurance contracts, and the timing and ultimate amount of actual claims related to these reserves is uncertain.

Investments in Variable Interest Entities. In December 2012, TransRe obtained an ownership interest in Pillar Capital Holdings Limited, or “Pillar Holdings,” a Bermuda-based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities. Additionally, TransRe invested $175.0 million and AIHL invested $25.0 million in limited partnership funds, or the “Funds,” which are managed by Pillar Holdings. The objective of the Funds is to create portfolios with attractive risk-reward characteristics and low correlation with other asset classes, utilizing the extensive reinsurance and capital market experience of the principals of Pillar Holdings. We have concluded that both Pillar Holdings and the Funds represent variable interest entities and that we are not the primary beneficiary, as we do not have the ability to direct the activities that most significantly impact each entity’s economic performance. Therefore, Pillar Holdings and the Funds are not consolidated, and are accounted for under the equity method of accounting. Alleghany’s potential maximum loss is limited to its aggregate investment of $200.0 million. As of December 31, 2012, our carrying value in Pillar Holdings and the Funds, as determined under the equity method of accounting, was $200.0 million, which is reported in other invested assets on our consolidated balance sheets.

Subsidiaries

Financial strength is also a high priority of our subsidiaries, whose assets stand behind their financial commitments to their customers and vendors. We believe that our subsidiaries have and will have adequate internally generated funds, cash resources, and unused credit facilities to provide for the currently foreseeable needs of their businesses. Our subsidiaries have no material commitments for capital expenditures.

The obligations and cash outflow of our reinsurance and insurance operating units include claim settlements, commission expenses, administrative expenses, purchases of investments, and interest and principal payments on the TransRe Senior Notes. In addition to premium collections, cash inflow is obtained from interest and dividend income and maturities and sales of investments. Because cash inflow from premiums is received in advance of cash outflow required to settle claims, our reinsurance and insurance operating units accumulate funds which they invest pending the need for liquidity. As a reinsurance or an insurance company’s cash needs can be unpredictable due to the uncertainty of the claims settlement process, our reinsurance and insurance operating units’ portfolios consist primarily of debt securities and short-term investments to ensure the availability of funds and maintain a sufficient amount of liquid securities.

Consolidated Investment Holdings

Investment Strategy and Holdings. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize our risk-adjusted, after-tax rate of return. Our 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 catastrophe losses. Our consolidated investment portfolio currently consists mainly of highly rated and liquid debt securities and equity securities listed on national securities exchanges. The overall debt securities portfolio credit quality is measured using the lower of the S&P, Moody’s or Fitch’s Ratings rating. In this regard, the overall weighted-average credit quality rating of our debt securities portfolio as of December 31, 2012 was “AA-.” Although many of our debt securities, which consist predominantly of municipal bonds, are insured by third party financial guaranty

 

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insurance companies, the impact of such insurance was not significant to the debt securities credit quality rating as of December 31, 2012. As of December 31, 2012, the ratings of our debt securities portfolio was as follows (in millions, except percentages):

 

     Ratings as of December 31, 2012  
     AAA /Aaa     AA / Aa     A     BBB /Baa     Below
BBB /Baa
or Not-Rated*
    Total  

U.S. Government obligations

   $      $ 522.9      $      $      $      $ 522.9   

Municipal bonds

     873.0        4,320.3        927.1        118.6        65.1        6,304.1   

Foreign government obligations

     540.4        157.1        112.6               5.9        816.0   

U.S. corporate bonds

     18.8        481.5        1,890.0        1,056.4        69.0        3,515.7   

Foreign corporate bonds

     349.7        565.4        987.9        262.5        33.0        2,198.5   

Mortgage and asset-backed securities:

            

RMBS

     48.8        1,477.6        51.4        2.8        81.9        1,662.5   

CMBS

     386.7        65.3        29.9        14.8        13.4        510.1   

Other asset-backed securities

     419.0        15.9        32.9        1.6        0.3        469.7   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total debt securities

   $ 2,636.4      $ 7,606.0      $ 4,031.8      $ 1,456.7      $ 268.6      $ 15,999.5   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Percentage of debt securities

     16.5     47.5     25.2     9.1     1.7     100.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

* Consists of $59.7 million of securities rated “BB / Ba,” $55.2 million of securities rated “B,” $45.8 million of securities rated “CCC,” $27.9 million of securities rated “CC,” $5.3 million of securities rates below “CC” and $74.7 million of not-rated securities.

Our debt securities portfolio has been designed to enable management to react to investment opportunities created by changing interest rates, prepayments, tax and credit considerations or other factors, or to circumstances that could result in a mismatch between the desired duration of debt securities and the duration of liabilities, and, as such, is classified as AFS.

Effective duration measures a portfolio’s sensitivity to change in interest rates. In this regard, as of December 31, 2012, our debt securities portfolio had an effective duration of approximately 3.7 years compared with 4.0 years as of December 31, 2011. As of December 31, 2012, approximately $5.6 billion, or 35.0 percent, of our debt securities portfolio represented securities with maturities of five years or less. See Note 4 to the Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for additional detail on the contractual maturities of our consolidated debt securities portfolio. We may modestly increase the proportion of our debt securities portfolio held in securities with maturities of more than five years should the yields of these securities provide, in our judgment, sufficient compensation for their increased risk. We do not believe that this strategy would reduce our ability to meet ongoing claim payments or to respond to significant catastrophe losses.

In the event paid losses accelerate beyond the ability of our reinsurance and insurance operating units to fund these paid losses from current cash balances, current operating cash flow, coupon receipts and security maturities, we would need to liquidate a portion of our investment portfolio, make capital contributions to our reinsurance and insurance operating units, and/or arrange for financing. Strains on liquidity could result from: (i) the occurrence of several significant catastrophic events in a relatively short period of time; (ii) the sale of investments into a depressed marketplace to fund these paid losses; (iii) the uncollectibility of reinsurance recoverables on these paid losses; (iv) the significant decrease in the value of collateral supporting reinsurance recoverables; or (v) a significant reduction in our net premium collections.

 

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We may, from time to time, make significant investments in the common stock of a public company, subject to limitations imposed by applicable regulations.

On a consolidated basis, our invested assets were approximately $18.3 billion as of December 31, 2012, an increase of 279.7 percent from December 31, 2011. The increase is due primarily to the investments acquired as a result of the merger, and, to a lesser extent, the proceeds received from our issuance of the 2022 Senior Notes discussed above.

Fair Value. The carrying values and estimated fair values of our consolidated financial instruments as of December 31, 2012 and 2011 were as follows (in millions):

 

     December 31, 2012      December 31, 2011  
     Carrying
Value
     Fair
Value
     Carrying
Value
     Fair
Value
 

Assets

           

Investments (excluding equity method investments)*

   $ 17,831.8       $ 17,831.8       $ 4,670.6       $ 4,670.6   

Liabilities

           

Senior Notes

   $ 1,811.5       $ 1,946.7       $ 299.0       $ 314.8   

 

* This table includes AFS investments (debt and equity securities as well as partnership investments carried at fair value that are included in other invested assets). This table excludes investments accounted for using the equity method and certain loans receivable that are carried at cost, all of which are included in other invested assets. The fair value of short-term investments approximates amortized cost. The fair value of all other categories of investments is discussed below.

Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between willing, able and knowledgeable market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. In addition, a three-tiered hierarchy for inputs is used in management’s determination of fair value of financial instruments that emphasizes the use of observable inputs over the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs are the reporting entity’s own assumptions about market participant assumptions based on the best information available under the circumstances. In assessing the appropriateness of using observable inputs in making our fair value determinations, we consider whether the market for a particular security is “active” or not based on all the relevant facts and circumstances. A market may be considered to be inactive if there are relatively few recent transactions or if there is a significant decrease in market volume. Furthermore, we consider whether observable transactions are “orderly” or not. We do not consider a transaction to be orderly if there is evidence of a forced liquidation or other distressed condition, and as such, little or no weight is given to that transaction as an indicator of fair value.

Although we are responsible for the determination of the fair value of the financial assets and the supporting methodologies and assumptions, we employ third party valuation service providers to gather, analyze and interpret market information and derive fair values based upon relevant methodologies and assumptions for individual instruments. When those providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting a quote, which is generally non-binding, from brokers who are knowledgeable about these securities or by employing widely accepted internal valuation models.

Valuation service providers typically obtain data about market transactions and other key valuation model inputs from multiple sources and, through the use of widely accepted internal valuation models, provide a single fair value measurement for individual securities for which a fair value has been requested under the terms of service agreements. The inputs used by the valuation service providers include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, currency rates, and other market observable information, as applicable. The valuation models take into account, among other things, market observable information as of the measurement date as well as the specific attributes of the security being valued including its term, interest rate, credit rating, industry sector, and

 

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when applicable, collateral quality and other issue or issuer specific information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.

The three-tiered hierarchy used in management’s determination of fair value is broken down into three levels based on the reliability of inputs as follows:

 

   

“Level 1”—Valuations are based on unadjusted quoted prices in active markets that we have the ability to access for identical, unrestricted assets, and do not involve any meaningful degree of judgment. An active market is defined as a market where transactions for the financial instrument occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Our Level 1 assets include publicly traded common stocks and mutual funds (which are included on the balance sheet in equity securities), where our valuations are based on quoted market prices.

 

   

“Level 2”—Valuations are based on direct and indirect observable inputs other than quoted market prices included in Level 1. Level 2 inputs include quoted prices for similar assets in active markets and inputs other than quoted prices that are observable for the asset, such as the terms of the security and market-based inputs. Terms of the security include coupon, maturity date, and any special provisions that may, for example, enable the investor, at its election, to redeem the security prior to its scheduled maturity date. Market-based inputs include interest rates and yield curves that are observable at commonly quoted intervals and current credit rating(s) of the security. Level 2 assets generally include short-term investments and most debt securities. Our Level 2 liabilities consist of the Senior Notes.

 

   

“Level 3”—Valuations are based on techniques that use significant inputs that are unobservable. The valuation of Level 3 assets requires the greatest degree of judgment. These measurements may be made under circumstances in which there is little, if any, market activity for the asset. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment. In making the assessment, we consider factors specific to the asset. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Some Level 3 valuations are based entirely on non-binding broker quotes. These securities consist primarily of mortgage and asset-backed securities where reliable pool and loan level collateral information cannot be reasonably obtained. Assets classified as Level 3 principally include certain RMBS, CMBS, other asset-backed securities, and partnership investments. See Note 1(c) to Notes to Consolidated Financial Statements set forth in Part II, Item 8 of this Form 10-K for our accounting policy on fair value.

We employ specific control processes to determine the reasonableness of the fair values of our financial assets and liabilities. Our processes are designed to ensure that the values received or internally estimated are accurately recorded and that the data inputs and the valuation techniques used are appropriate, consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. We assess the reasonableness of individual security values received from valuation service providers through various analytical techniques. In addition, we validate the reasonableness of fair values by comparing information obtained from our valuation service providers to other third party valuation sources for selected securities. We also validate prices obtained from brokers for selected securities through reviews by those who have relevant expertise and who are independent of those charged with executing investing transactions.

In addition to such procedures, we review the reasonableness of our classification of securities within the three-tiered hierarchy to ensure that the classification is consistent with GAAP.