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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2003
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: 0-14950
Argonaut Group, Inc.
(Exact name of Registrant as specified in its charter)
Delaware 95-4057601
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10101 Reunion Place, Suite 500, San Antonio, Texas 78216
(Address of principal executive offices) (Zip code)
(210) 321-8400
(Registrant's telephone number including area code)
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 X No ____
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes X No ____
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of November 14, 2003.
Title Outstanding
Common Stock, par value $0.10 per share 26,943,755
ARGONAUT GROUP, INC.
TABLE OF CONTENTS
Page No.
Part I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
September 30, 2003 and December 31, 2002........................... 3
Condensed Consolidated Statements of Operations
Three and nine months ended September 30, 2003 and 2002............ 4
Condensed Consolidated Statements of Comprehensive Income (Loss)
Three and nine months ended September 30, 2003 and 2002............ 5
Condensed Consolidated Statements of Cash Flow
Nine months ended September 30, 2003 and 2002...................... 6
Notes to Condensed Consolidated Financial Statements................. 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations........................ 15
Item 3. Market Risks.................................................. 24
Item 4. Controls and Procedures....................................... 25
Part II. OTHER INFORMATION:
Item 1. Legal Proceedings............................................. 26
Item 2. Changes in Securities and Use of Proceeds..................... 26
Item 3. Default Upon Senior Securities................................ 26
Item 4. Submission of Matters to a vote of Security Holders........... 26
Item 5. Other Information............................................. 26
Item 6. Exhibits and Reports on Form 8-K ................................26
2
Part I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in millions, except per share amounts)
September 30, December 31,
2003 2002
-------------- --------------
(Unaudited)
Assets:
Investments:
Fixed maturities, at fair value (cost: 2003 - $1,047.5; 2002 - $850.7) $ 1,092.3 $ 894.1
Equity securities, at fair value (cost: 2003 - $108.1; 2002 - $149.2) 158.2 237.1
Other long-term investments, at fair value (cost: 2003 - $12.1; 2002 - $10.8) 11.9 10.0
Short-term investments, at fair value which approximates cost 175.7 40.1
-------------- --------------
Total investments 1,438.1 1,181.3
-------------- --------------
Cash and cash equivalents 60.5 77.4
Accrued investment income 12.9 13.0
Premiums receivable 260.9 221.6
Reinsurance recoverable 483.0 470.1
Notes receivable 47.1 -
Goodwill 105.7 105.7
Deferred federal income tax asset, net 5.7 20.0
Deferred acquisition costs, net 63.3 54.7
Other assets 91.0 65.1
-------------- --------------
Total assets $ 2,568.2 $ 2,208.9
============== ==============
Liabilities:
Reserves for losses and loss adjustment expenses $ 1,399.8 $ 1,281.6
Unearned premiums 355.3 284.9
Funds held 182.2 163.6
Deferred gain, retroactive reinsurance 42.5 40.0
Junior subordinated debentures 15.5 -
Related party note payable 12.0 -
Income taxes payable, net 15.7 1.5
Accrued expenses and other liabilities 129.0 109.6
-------------- --------------
Total liabilities 2,152.0 1,881.2
-------------- --------------
Shareholders' equity:
Preferred stock -$0.10 par, 5,000,000 shares authorized Series A mandatory
convertible preferred stock - 2,953,310 and 0 shares
issued and outstanding at September 30, 2003 and December 31, 2002 0.3 -
Common stock - $0.10 par, 35,000,000 shares authorized; 21,608,684 and 21,602,082
shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively 2.2 2.2
Additional paid-in capital 131.3 96.4
Retained earnings 222.7 145.9
Deferred stock compensation (1.9) (1.7)
Accumulated other comprehensive income, net 61.6 84.9
-------------- --------------
Total shareholders' equity 416.2 327.7
-------------- --------------
Total liabilities and shareholders' equity $ 2,568.2 $ 2,208.9
============== ==============
See accompanying notes.
3
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in millions, except per share amounts)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- ----------------------------
2003 2002 2003 2002
-------------- ------------- ------------- -------------
Premiums and other revenue:
Earned premiums $ 148.1 $ 96.3 $ 417.1 $ 264.9
Net investment income 13.3 12.9 40.1 40.0
Realized investment gains, net 48.5 1.2 112.2 15.2
-------------- ------------- ------------- -------------
Total revenue 209.9 110.4 569.4 320.1
-------------- ------------- ------------- -------------
Expenses:
Losses and loss adjustment expenses 105.6 70.9 294.4 195.1
Underwriting, acquisition, and
insurance expenses 48.9 33.4 148.5 98.8
Interest expense 1.9 - 6.0 -
-------------- ------------- ------------- -------------
Total expenses 156.4 104.3 448.9 293.9
-------------- ------------- ------------- -------------
Income before income taxes 53.5 6.1 120.5 26.2
Provision for income taxes 28.8 1.4 42.5 7.9
-------------- ------------- ------------- -------------
Net income $ 24.7 $ 4.7 $ 78.0 $ 18.3
============== ============= ============= =============
Net income per common share:
Basic $ 1.11 $ 0.22 $ 3.55 $ 0.85
============== ============= ============= =============
Diluted $ 1.00 $ 0.22 $ 3.30 $ 0.84
============== ============= ============= =============
Dividends declared per common share: $ - $ 0.15 $ - $ 0.45
============== ============= ============= =============
Weighted average common shares:
Basic 21,608,452 21,575,262 21,606,337 21,565,687
============== ============= ============= =============
Diluted 24,593,984 21,646,263 23,613,989 21,667,228
============== ============= ============= =============
See accompanying notes.
4
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in millions)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income $ 24.7 $ 4.7 $ 78.0 $ 18.3
------------ ------------ ------------ ------------
Other comprehensive income (loss):
Unrealized gains (losses) on securities:
Gains (losses) arising during the period (7.6) (40.5) 18.8 (20.2)
Reclassification adjustment for gains included
in net income or loss (48.5) (1.2) (54.6) (15.2)
------------ ------------ ------------ ------------
Other comprehensive loss before tax (56.1) (41.7) (35.8) (35.4)
Income tax benefit related to other
comprehensive loss (19.6) (14.6) (12.5) (12.4)
------------ ------------ ------------ ------------
Other comprehensive loss, net of tax (36.5) (27.1) (23.3) (23.0)
------------ ------------ ------------ ------------
Comprehensive income (loss) $ (11.8) $ (22.4) $ 54.7 $ (4.7)
============ ============ ============ ============
See accompanying notes
5
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(Dollars in millions)
(Unaudited)
Nine Months Ended
September 30,
---------------------------
2003 2002
------------ ------------
Cash flows from operating activities:
Net income $ 78.0 $ 18.3
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization and depreciation 8.3 8.9
Deferred federal income tax expense 26.8 8.3
Gains on sales of investments (54.6) (15.2)
Gains on sales of real estate (57.6) -
Change in:
Accrued investment income 0.2 1.5
Receivables (52.2) (54.1)
Unearned premiums on ceded reinsurance (31.0) (13.5)
Reserves for losses and loss adjustment expenses 118.2 11.8
Unearned premiums 70.4 96.8
Other assets and liabilities, net 23.3 (11.0)
------------ ------------
Cash provided by operating activities 129.8 51.8
------------ ------------
Cash flows from investing activities:
Sales of fixed maturity investments 39.1 53.8
Maturities and mandatory calls of fixed maturity investments 156.7 92.9
Sales of equity securities 95.8 30.9
Purchases of fixed maturity investments (396.9) (188.5)
Purchases of equity securities (2.0) (13.4)
Change in short-term investments (135.7) (11.3)
Sale of real estate 57.6 -
Notes receivable for real estate, net (47.1) -
Other, net 24.3 8.4
------------ ------------
Cash used by investing activities (208.2) (27.2)
------------ ------------
Cash flows from financing activities:
Issuance of Series A mandatory convertible preferred stock 34.6 -
Issuance of junior subordinated debentures 15.5 -
Related party note payable 12.0 -
Stock options exercised - 0.4
Payment of cash dividend on common stock - (9.7)
Payment of cash dividend on preferred stock (0.6) -
------------ ------------
Cash provided (used) by financing activities: 61.5 (9.3)
------------ ------------
Change in cash and cash equivalents (16.9) 15.3
Cash and cash equivalents, beginning of period 77.4 14.0
------------ ------------
Cash and cash equivalents, end of period $ 60.5 $ 29.3
============ ============
Additional disclosure:
Income taxes paid $ 4.1 $ 0.8
============ ============
See accompanying notes
6
ARGONAUT GROUP, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
Note 1 - Basis of Presentation
The accompanying Condensed Consolidated Financial Statements of Argonaut Group,
Inc. and Subsidiaries (collectively "Argonaut Group" or "the Company") have been
prepared in conformity with accounting principles generally accepted in the
United States of America (GAAP) for interim financial information and with the
instructions for Form 10-Q and Article 10 of Regulation S-X. Certain financial
information that is normally included in annual financial statements, including
certain financial statement footnotes, prepared in accordance with GAAP, is not
required for interim reporting purposes and has been condensed or omitted. These
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Annual Report on Form
10-K/A for the year ended December 31, 2002 that the Company filed with the
Securities and Exchange Commission on July 24, 2003.
The interim financial data as of September 30, 2003 and 2002 and for the three
months and nine months ended September 30, 2003 and 2002 is unaudited. However,
in the opinion of management, the interim data include all adjustments,
consisting of normal recurring accruals, necessary for a fair statement of the
Company's results for the interim periods. The operating results for the interim
periods are not necessarily indicative of the results to be expected for the
full year. All significant intercompany amounts have been eliminated. Certain
amounts applicable to prior periods have been reclassified to conform to the
presentation followed in 2003.
The balance sheet at December 31, 2002 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by GAAP for complete financial statements.
Note 2 - Recently Issued Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires that the
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred, not at the date of an entity's commitment to an
exit or disposal plan. The provisions of SFAS No. 146 are effective for exit or
disposal activities initiated after December 31, 2002. In the first quarter of
2003, the Company restructured the Risk Management segment of Argonaut Insurance
Company, which was accounted for in accordance with SFAS No. 146. With the
elimination of non-strategic products, Argonaut Insurance Company has reduced
its workforce by 67 employees as of September 30, 2003, and anticipates the
reduction of an additional two employees in 2004. Severance costs of $0.9
million and outplacement and relocation costs of $0.3 million had been
recognized as of September 30, 2003. Additionally, the Company closed three
offices at a total cost of $0.3 million. The costs associated with the
restructuring are included in the underwriting, acquisition and insurance
expenses line item in the accompanying condensed consolidated statements of
operations. No material costs associated with the restructuring were incurred in
the third quarter of 2003.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosures." SFAS No. 148 establishes alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. In addition, the statement amends the
disclosure requirements of SFAS No. 123, "Accounting for Stock-Based
Compensation" to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. SFAS No. 148
is effective for financial statements for fiscal years ending after December 15,
2002. The Company adopted the provisions of SFAS No. 148 relating to pro forma
reporting effective December 2002. The Company has not made a determination
regarding accounting for stock-based compensation on the fair value method (see
note 5).
7
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liability and Equity". This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. This
statement is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. The Company elected to adopt SFAS No. 150
in the second quarter of 2003. There was no impact from the adoption of SFAS No.
150 on the Company's consolidated financial position, results of operations or
cash flows.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46). It requires that the assets, liabilities
and results of the activity of variable interest entities be consolidated into
the financial statements of the company that has controlling financial interest.
It also provides the framework for determining whether a variable interest
entity should be consolidated based on voting interest or significant financial
support provided to it. FIN 46 is effective for variable interest entities
created after January 31, 2003 in the second quarter of 2003. The effective date
for variable interest entities created before February 1, 2003 is for financial
statements issued after December 15, 2003. FIN 46 is not expected to have a
material impact on the Company's consolidated financial position, results of
operations or cash flows.
Note 3 - Earnings Per Share
The following table presents the calculation of basic and diluted net income per
common share for the three and nine months ended September 30, 2003 and 2002:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- --------------------------------
(Dollars in millions except per share data) 2003 2002 2003 2002
-------------- --------------- --------------- --------------
Net income $ 24.7 $ 4.7 $ 78.0 $ 18.3
Preferred stock dividends (0.6) - (1.2) -
-------------- --------------- --------------- --------------
Income available to common shareholders $ 24.1 $ 4.7 $ 76.8 $ 18.3
Effect of dilutive securities:
Preferred stock dividends 0.6 - 1.2 -
-------------- --------------- --------------- --------------
Income available to common shareholders
after assumed conversion 24.7 4.7 78.0 18.3
Weighted average shares-basic 21,608,452 21,575,262 21,606,337 21,565,687
Effect of dilutive securities:
Stock options 32,222 71,001 17,143 101,541
Convertible preferred stock 2,953,310 - 1,990,509 -
-------------- --------------- --------------- --------------
Weighted average shares-diluted 24,593,984 21,646,263 23,613,989 21,667,228
============== =============== =============== ==============
Net income per common share-basic $ 1.11 $ 0.22 $ 3.55 $ 0.85
Net income per common share-diluted $ 1.00 $ 0.22 $ 3.30 $ 0.84
For the three and nine months ended September 30, 2003, options to purchase
1,655,800 shares of common stock at a price ranging from $15.70 to $35.50 were
not included in the computation of diluted earnings per share because the
options' exercise price was greater than the average market price of the common
shares. These options expire at varying times from 2004 through 2013. For the
three and nine months ended September 30, 2002, options to purchase 931,400
shares of common stock at a price ranging from $19.50 to $35.50 were not
included in the computation of diluted earnings per share because the options'
exercise price was greater than the average market price of the common shares.
These options expire at varying times from 2003 through 2012. On November 3,
2003, the Company sold 4.8 million shares of its common stock through an
underwritten public offering. In addition, HCC Insurance Holdings, Inc.,
concurrent with the closing of the underwritten public offering, purchased from
the Company 533,173 shares of the Company's common stock in a private placement
(see note 12).
8
Note 4 - Income Taxes
The Company's income tax provision includes the following components:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
(in millions) 2003 2002 2003 2002
------------- ------------ ------------- ------------
Current tax provision related to:
Current tax provision (benefit) $ 9.2 $ (0.6) $ 15.7 $ 0.2
Deferred tax provision (benefit) related to:
Future tax deductions (4.2) (1.2) (10.2) (1.0)
Net operating loss carryforward 22.4 2.9 49.6 8.7
Deferred alternative minimum tax provision (9.1) 0.3 (10.7) -
Valuation allowance change 10.5 - (1.9) -
------------- ------------ ------------- ------------
Income tax provision $ 28.8 $ 1.4 $ 42.5 $ 7.9
============= ============ ============= ============
A reconciliation of the Company's income tax provision to the provision which
would have resulted if the tax had been computed at the statutory rate is as
follows:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
(in millions) 2003 2002 2003 2002
------------- ------------ ------------- ------------
Income tax provision at statutory rates (35%) $ 18.7 $ 2.2 $ 40.4 $ 9.2
Tax effect of:
Tax exempt interest - - (0.1) (0.2)
Dividends received deduction (0.1) (0.3) (0.6) (0.9)
Valuation allowance change 10.5 - (1.9) -
Other permanent adjustments, net (0.3) (0.2) (0.3) (0.1)
State income tax provision - (0.3) 5.0 (0.1)
------------- ------------ ------------- ------------
Income tax provision $ 28.8 $ 1.4 $ 42.5 $ 7.9
============= ============ ============= ============
Note 5 - Stock-Based Compensation
The Company accounts for its stock option plans in accordance with the
provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations. As such, compensation expense
would be recorded on the date of grant only if the current market price of the
underlying stock exceeded the exercise price.
As of September 30, 2003, the Company had 128,349 shares of non-vested stock
issued and outstanding. The non-vested shares vest in equal annual installments
over a period of two to three years, subject to continued employment. The stock
is not issued until the vesting requirements are met. Thus, the stock does not
carry any voting or dividend rights. Compensation expense for non-vested stock
awards is based on the market price of the stock on the date of grant and is
recognized ratably over the vesting period of the award. For the three months
ended September 30, 2003 and 2002, the Company recognized deferred stock
compensation expense of $0.2 million and $0.3 million, respectively. For the
nine months ended September 30, 2003 and 2002, the Company recognized deferred
stock compensation expense of $0.7 million and $0.4 million, respectively.
In August, 2003, the Company granted selected executives and other key employees
stock option awards whose vesting is contingent upon the employee meeting
defined performance measures. Upon meeting the performance measures, the options
will vest over a four year term. The options granted under this variable plan
resulted in approximately $0.3 million of compensation expense being deferred as
of September 30, 2003. Compensation expense recognized as a result of theses
grants was not material.
9
Had the Company determined compensation cost based on the fair value at the
grant date for its stock options under SFAS No. 123, "Accounting for Stock-Based
Compensation," the Company's net income and income per common share would have
been reduced to the pro forma amounts indicated below:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
(in millions, except per share amounts) 2003 2002 2003 2002
------------- ------------ ------------- ------------
Net income, as reported $ 24.7 $ 4.7 $ 78.0 $ 18.3
Add: Total deferred stock compensation expense included
in reported net income, net of taxes 0.1 0.2 0.5 0.3
Deduct: Total stock-based employee compensation
determined under fair value based methods for all
awards, net of tax (0.2) (0.3) (0.8) (0.5)
------------- ------------ ------------- ------------
Pro forma net income $ 24.6 $ 4.6 $ 77.7 $ 18.1
============= ============ ============= ============
Earnings per share
Basic - as reported $ 1.11 $ 0.22 $ 3.55 $ 0.85
Basic - pro forma $ 1.11 $ 0.22 $ 3.54 $ 0.84
Diluted - as reported $ 1.00 $ 0.22 $ 3.30 $ 0.84
Diluted - pro forma $ 1.00 $ 0.21 $ 3.29 $ 0.84
Note 6 - Reserves for Losses and Loss Adjustment Expenses
The following table provides a reconciliation of the beginning and ending
reserve balances for losses and loss adjustment expenses ("LAE"), net of
reinsurance, to the gross amounts reported in the balance sheet. Reinsurance
recoverables in this note exclude paid loss recoverables of $22.7 million and
$37.6 million as of September 30, 2003 and 2002, respectively.
Nine Months Ended
September 30,
-----------------------
(Dollars in millions) 2003 2002
----------- -----------
Net reserves - beginning of year $ 838.2 $ 929.6
Net reserves from renewal rights acquisition 3.2 -
Net reserves ceded under retroactive reinsurance contracts (2.5) -
Add:
Loss and LAE incurred during calendar year, net of reinsurance:
Current accident year 272.0 189.3
Prior accident years 22.4 5.8
----------- -----------
Loss and LAE incurred during current accident year, net of reinsurance 294.4 195.1
Deduct:
Loss and LAE payments made during current calendar year, net of reinsurance:
Current accident year 46.9 36.0
Prior accident years 146.9 155.0
----------- -----------
Loss and LAE payments made during current calendar year, net of reinsurance: 193.8 191.0
----------- -----------
Net reserves, end of period 939.5 933.7
Add:
Reinsurance recoverable on unpaid losses & LAE, end of period 460.3 225.8
----------- -----------
Gross reserves - end of period $ 1,399.8 $ 1,159.5
=========== ===========
Adverse development during 2003 was primarily the result of $5.0 million of
development attributable to one multi-year construction account combined with
strengthening of the allowance for uncollectible reinsurance reserves of $15.2
million. Adverse development during 2002 was primarily the result of reserve
strengthening for the run-off lines.
10
Note 7 - Business Segments
The Company is primarily engaged in writing property and casualty insurance. The
Company has classified its business into the following four continuing segments:
excess and surplus lines, specialty commercial, risk management (formerly
specialty workers' compensation) and public entity. Additionally, the Company no
longer underwrites certain coverages and classifies the results as run-off for
purposes of segment reporting. The Company considers many factors, including the
nature of the segment's insurance products, production sources, distribution
strategies and regulatory environment in determining how to aggregate operating
segments.
In evaluating the operating performance of its segments, the Company focuses on
core underwriting and investing results before the consideration of realized
gains or losses from the sales of investments. Realized investment gains
(losses) are reported as a component of the corporate and other segment, as
decisions regarding the acquisition and disposal of securities reside with the
executive management of the Company and are not under the control of the
individual business segments. Identifiable assets by segment are those assets
used in the operation of each segment. Identifiable assets are not assigned to
run-off lines.
Revenues and income before taxes for each reporting group were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
(in millions) 2003 2002 2003 2002
------------ ------------ ------------ ------------
Revenues:
Earned premiums
Excess & surplus lines $ 75.3 $ 39.9 $ 209.9 $ 99.5
Risk management 31.7 26.3 95.7 80.9
Specialty commercial 31.9 27.1 90.1 77.8
Public entity 9.2 3.0 21.4 6.7
Run-off lines - - - -
------------ ------------ ------------ ------------
Total earned premiums 148.1 96.3 417.1 264.9
Net investment income
Excess & surplus lines 4.0 2.8 11.5 7.6
Risk management 6.9 7.5 20.8 24.1
Specialty commercial 2.4 2.5 7.1 7.5
Public entity 0.2 0.1 0.5 0.4
Run-off lines - - - -
Corporate & other (0.2) - 0.2 0.4
------------ ------------ ------------ ------------
Total net investment income 13.3 12.9 40.1 40.0
Realized investment gains, net 48.5 1.2 112.2 15.2
------------ ------------ ------------ ------------
Total revenue $ 209.9 $ 110.4 $ 569.4 $ 320.1
============ ============ ============ ============
Income (loss) before income tax
Excess & surplus lines 11.7 5.8 30.6 12.0
Risk management 2.8 3.9 (13.9) 1.8
Specialty commercial 2.5 3.0 5.9 7.5
Public entity 1.1 0.1 1.7 -
Run-off lines (10.2) (7.2) (10.2) (7.8)
------------ ------------ ------------ ------------
Total segment income before taxes 7.9 5.6 14.1 13.5
Corporate & other (2.9) (0.7) (5.8) (2.5)
Net realized investment gains 48.5 1.2 54.6 15.2
Net realized gains on sales of real estate - - 57.6 -
------------ ------------ ------------ ------------
Total income before income tax $ 53.5 $ 6.1 $ 120.5 $ 26.2
============ ============ ============ ============
11
Identifiable assets for each reporting group were as follows:
September 30, December 31,
(in millions) 2003 2002
--------------- ---------------
Excess & surplus lines $ 674.7 $ 498.6
Risk management 1,455.6 1,324.5
Specialty commercial 356.3 351.3
Public entity 81.5 33.4
Run-off lines - -
Corporate & other 0.1 1.1
--------------- ---------------
Total $ 2,568.2 $ 2,208.9
=============== ===============
Note 8 - Other Assets
Other assets were comprised of:
September 30, December 31,
in millions 2003 2002
---------------- ---------------
Ceded unearned premiums $ 61.6 $ 30.6
Furniture, fixtures and equipment, net 15.7 17.9
Agency plant 5.0 6.1
Prepaid assets 4.4 4.1
Capital lease 1.3 1.3
Other 3.0 5.1
---------------- ---------------
Total other assets $ 91.0 $ 65.1
================ ===============
Note 9 - Underwriting, Acquisition and Insurance Expenses
Underwriting, acquisition and insurance expenses for the three and nine months
ended September 30, 2003 and 2002 were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- ------------------------------
(in millions) 2003 2002 2003 2002
------------- ------------- -------------- --------------
Commissions $ 32.9 $ 20.3 $ 78.9 $ 49.4
General Expenses 15.6 22.2 60.8 57.7
State assessments 1.9 2.7 7.5 6.7
Taxes, licenses and bureau fees 3.8 4.3 9.7 10.7
------------- ------------- -------------- --------------
54.2 49.5 156.9 124.5
Deferral of policy acquisition costs (5.3) (16.1) (8.4) (25.7)
------------- ------------- -------------- --------------
Total underwriting, acquisition and
insurance expense $ 48.9 $ 33.4 $ 148.5 $ 98.8
============= ============= ============== ==============
Note 10 - Related Party Transactions
The Company utilizes Fayez Sarofim & Co. to manage a portion of its investment
portfolio, for which an investment advisory fee is calculated and payable
quarterly based upon the fair market value of the assets under management. For
the nine months ended September 30, 2003, these payments totaled $0.4 million.
Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez
Sarofim is the majority shareholder. Mr. Sarofim is a member of the Company's
board of directors. As of September 30, 2003, Fayez Sarofim & Co. managed $153.0
million of the Company's investments. The Company believes that this transaction
has been entered into on terms no less favorable than could have been negotiated
with non-affiliated third parties.
12
On March 31, 2003, the Company sold 2,453,310 shares of Series A Mandatory
Convertible Preferred Stock ("the preferred shares") at an offering price of $12
per share to HCC Insurance Holdings, Inc. ("HCC"). Additionally, effective March
31, 2003, the Company sold an additional 500,000 shares to an unrelated
investor. The preferred shares will initially pay a 7 percent dividend on a
quarterly basis. The dividend is cumulative, and is payable when declared by the
board of directors. As of September 30, 2003, dividends of $1.2 million were
declared, with $0.6 million being accrued and payable as of September 30, 2003.
On March 31, 2003, the Company borrowed $18.0 million from HCC. The note payable
is due March 31, 2006, bears interest at 12% annually and is prepayable at the
Company's option at anytime. The note contains certain covenants, one of which
requires repayment should the Company enter into other debt agreements or issue
additional shares of Series A Mandatory Convertible Preferred Stock. On April
16, 2003, the Company repaid $6.0 million principal amount of the note, plus
accrued interest in conjunction with the issuance and proceeds of the additional
preferred shares. On May 7, 2003, the Company received a waiver from HCC of the
requirement to use proceeds from the Company's issuance of its Floating Rate
Junior Subordinated Deferrable Interest Debentures due 2033 to repay the note
payable (see note 11). In November 2003, HCC converted approximately $7.9
million of the outstanding balance of the note into the Company's common shares
(see note 12).
On March 31, 2003, Colony Insurance Company entered into a quota share
reinsurance agreement with HCC. As of September 30, 2003, the Company ceded
approximately $26.4 million of gross written premiums, $7.5 million of earned
premiums and $4.3 million of losses and loss adjustment expenses. Of this,
approximately $15.1 million of gross written premiums, $5.8 million of earned
premiums and $3.3 million of losses and loss adjustment expenses were ceded
during the third quarter 2003. The Company receives a ceding commission to
offset its acquisition costs related to these premiums. As of September 30,
2003, the Company had earned a ceding commission of $1.5 million.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share
reinsurance agreement with HCC. Under the terms of the agreement, the Company
will assume 3.33% of the losses under HCC's USA Directors and Officers Liability
program. Additionally, the Company will assume 5.0% of the losses under HCC's
International Directors and Officers Liability program. For the three and nine
months ending September 30, 2003, gross written premiums recorded under this
program totaled $3.8 million and $9.6 million, respectively. The Company will
pay to HCC ceding and other commissions to offset costs related to these
premiums. For the three and nine months ended September 30, 2003, the Company
expensed ceding and other commissions of $0.6 million and $1.1 million,
respectively.
On March 12, 2003, the Company entered into a reinsurance consulting agreement
with Rattner Mackenzie (Bermuda) Ltd., a wholly owned subsidiary of HCC,
pursuant to which Rattner Mackenzie provides reinsurance consulting advice to
the Company's insurance subsidiaries for an annual fee of $250,000. The
agreement expires on March 31, 2007. During 2003, the Company also paid Rattner
Mackenzie a brokerage fee of $58,470 for its services in placing a
property-catastrophe reinsurance agreement.
Note 11 -Junior Subordinated Debentures
On May 15, 2003, Argonaut Group Statutory Trust, a Connecticut statutory trust
and wholly-owned subsidiary of the Company, sold 15,000 Floating Rate Capital
Securities (the "Capital Securities") (liquidation amount $1,000 per Capital
Security) to I-Preferred Term Securities II, Ltd. in a private sale for $15.0
million. The Trust used the proceeds from this sale, together with the proceeds
from its sale of 464 shares of Floating Rate Common Securities (liquidation
amount $1,000 per Common Security) to the Company, to buy a series of Floating
Rate Junior Subordinated Deferrable Interest Debentures (the "Debentures") due
2033 from the Company. The Debentures have the same payment terms as the Capital
Securities.
13
The interest rate on the Debentures and the Capital Securities is equal to
3-Month LIBOR plus 4.10%, reset quarterly, not to exceed 12.5%. The Debentures
are unsecured and are subordinated in right of payment to all of the Company's
future senior indebtedness. Beginning in May 2008, the Company will have the
right to redeem the Debentures, in whole or in part, at a price equal to 100% of
the principal amount of the Debentures, plus accrued and unpaid interest to the
date of redemption. The Company will also have the right to redeem all of the
Debentures before May 2008 upon the happening of specified events at a price
equal to 107.5% of the principal amount of the Debentures, plus accrued and
unpaid interest to the date of redemption.
The Company used $12.0 million of the net proceeds from the sale of the
Debentures to increase the statutory capital of its insurance company
subsidiaries.
Note 12 - Subsequent Events
On November 3, 2003, the Company sold 4.8 million shares of its common stock,
par value $0.10 per share, in an underwritten public offering. The sale was made
pursuant to an Underwriting Agreement, dated October 28, 2003, by and among the
Company and Raymond James & Associates, Inc., as representative of the
underwriters. The common stock was issued at a price of $15.80 per share, less
an underwriting discount of 5.5%. The net proceeds from the sale of the common
stock were approximately $70.9 million, after deducting the underwriting
discounts and commissions and offering expenses. The Company intends to
contribute a majority of the net proceeds from this offering to its insurance
subsidiaries to support the continued growth of the business, improve the
regulatory capital adequacy ratios and maintain strong financial strength
ratings. The remainder of the net proceeds will be used for general corporate
purposes. The Company has also granted the underwriters an option to purchase an
additional 720,000 shares of common stock to cover over-allotments.
Concurrent with the closing of the underwritten public offering, HCC purchased
from the Company in a private placement 533,173 shares of the Company's common
stock at a price of $14.931 per share, which was equal to the public offering
price in the underwritten public offering less the underwriting discount. The
Company used the proceeds from this private placement to repay approximately
$7.9 million of the $12.0 million aggregate remaining principal amount of a note
payable to HCC, plus accrued interest on that portion of the note.
Effective November 14, 2003, the Company entered into an agreement to acquire
the renewal rights of Coregis Group, Inc, a unit of GE Capital Company. Under
the terms of the agreement, the Company will have the right to renew the
business currently underwritten by Coregis Group, Inc.'s public entity
underwriting group. The Company will also acquire certain assets and hire select
employees to service these accounts.
14
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition
The following is a discussion and analysis of the consolidated results of
operations and financial condition of Argonaut Group, Inc. and its subsidiaries
(collectively, "Argonaut Group" or the "Company") for the three and nine months
ended September 30, 2003 and 2002. It should be read in conjunction with the
consolidated financial statements and other data presented herein as well as
with the Management's Discussion and Analysis of Results of Operation and
Financial Condition contained in the Company's Annual Report on Form 10-K/A for
the year ended December 31, 2002 that the Company filed with the Securities and
Exchange Commission on July 24, 2003.
Forward Looking Statements
Management's Discussion and Analysis of Results of Operations and Financial
Conditions, Quantitative and Qualitative information about Market Risk and the
accompanying Condensed Consolidated Financial Statements (including the notes
thereto) contain "forward looking statements" which are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
The forward-looking statements are based on the Company's current expectations
and beliefs concerning future developments and their potential effects on the
Company. There can be no assurance that actual developments will be those
anticipated by the Company. Actual results may differ materially as a result of
significant risks and uncertainties, including non-receipt of the expected
payments, changes in interest rates, effect of the performance of financial
markets on investment income and fair values of investments, development of
claims and the effect on loss reserves, accuracy in projecting loss reserves,
the impact of competition and pricing environments, changes in the demand for
the Company's products, the effect of general economic conditions, adverse state
and federal legislation and regulations, developments relating to existing
agreements, heightened competition, changes in pricing environments, and changes
in asset valuations. The Company undertakes no obligation to publicly update any
forward-looking statements as a result of events or developments subsequent to
the date of this Quarterly Report.
Risk-Based Capital
The Company's insurance subsidiaries are subject to Risk-Based Capital ("RBC")
under The Insurers Model Act. RBC is designed to measure the adequacy of capital
for an insurance company based on the inherent specific risks of each insurer.
RBC is calculated on an annual basis, in conjunction with statutory financial
filings with the departments of insurance in which the Company transacts
business. At December 31, 2002, Argonaut Insurance Company's RBC was within the
Company Action Level Event. Argonaut Insurance Company's RBC would have been
within the Regulatory Action Level Event, if the California Department of
Insurance had not permitted Argonaut Insurance Company to report a parcel of
real estate at its sales price. During the first quarter of 2003, this parcel of
real estate was sold in accordance with the permitted practice granted by the
California Department of Insurance. Pursuant to the requirements under the
Company Action Level, Argonaut Insurance Company submitted to the California
Department of Insurance, on April 8, 2003, a Comprehensive Plan of Action.
During the nine months ended September 30, 2003, the Company contributed $53.4
million in capital to Argonaut Insurance Company. With the closing of the
Company's secondary common stock offering (see "Liquidity and Capital Resources"
discussion beginning on page 23) it is the Company's expectation that, absent a
material change to its financial results, Argonaut Insurance Company's RBC ratio
will be above the Company Action Level at December 31, 2003.
15
Results of operations
The following is a comparison of selected data from the Company's operations:
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ---------------------------
(in millions) 2003 2002 2003 2002
------------- ------------- ------------- ------------
Gross written premiums $ 220.1 $ 189.8 $ 593.6 $ 449.2
============= ============= ============= ============
Earned premiums $ 148.1 $ 96.3 $ 417.1 $ 264.9
Net investment income 13.3 12.9 40.1 40.0
Realized investment gains, net 48.5 1.2 112.2 15.2
------------- ------------- ------------- ------------
Total revenue $ 209.9 $ 110.4 $ 569.4 $ 320.1
============= ============= ============= ============
Income before taxes 53.5 6.1 120.5 26.2
Provision for income taxes 28.8 1.4 42.5 7.9
------------- ------------- ------------- ------------
Net income $ 24.7 $ 4.7 $ 78.0 $ 18.3
============= ============= ============= ============
Combined ratio 104.3% 108.3% 106.2% 111.0%
============= ============= ============= ============
The increase in consolidated gross written premiums and earned premiums was
primarily attributable to new business written during the three and nine months
ended September 30, 2003. For the three months ended September 30, 2003, gross
written premiums related to new business were $128.1 million compared to $104.3
million for the same period in 2002. For the nine months ended September 30,
2003, gross written premiums related to new business were $345.1 million
compared to $213.2 million for the same period in 2002. The increase in new
business was primarily attributable to a renewal rights acquisition within the
excess and surplus lines segment, which was effective in May 2002. Renewal gross
written premiums accounted for $97.6 million and $265.4 million for the three
and nine months ended September 30, 2003, respectively, compared to $89.4
million and $244.5 million for the three and nine months ended September 30,
2002, respectively. Partially offsetting these increases were cancellations and
endorsements, which reduced gross written premiums by approximately $5.6 million
and $16.9 million for the three and nine months ended September 30, 2003,
respectively. The increase in renewal gross written premiums was primarily
attributable to rate increases.
Consolidated net investment income was comparable between periods due to lower
yields offset by higher invested balances due to the investment of positive cash
flows. Consolidated invested assets totaled $1,438.1 million and $1,165.0
million at September 30, 2003 and 2002, respectively.
The Company manages its investment portfolio to minimize losses, both realized
and unrealized. During the three months ended September 30, 2003, the Company
re-allocated its investment portfolio and reduced its equity holdings by
approximately $86.3 million, resulting in realized investment gains of $48.5
million for the period then ended. Realized investment gains for the three
months ended September 30, 2003 are net of write downs for other than temporary
impairment of securities totaling $0.2 million, compared to $4.2 million for the
same period of 2002. Realized investment gains for the nine months ended
September 30, 2003 were $112.2 and include gains on sales of three real estate
holdings totaling $57.6 million. Included in realized investment gains as of
September 30, 2003, are write downs of $4.0 million due to the recognition of
other than temporary impairments of securities. Realized investment gains of
$15.2 million for the nine months ended September 30, 2002 include write downs
of $4.2 million for other than temporary impairment of securities.
The consolidated loss ratios were 71.3% and 70.6% for the three and nine months
ended September 30, 2003, respectively, compared to 73.6% and 73.7% for the
three and nine months ended September 30, 2002, respectively. The improvement in
the loss ratios was primarily attributable to the effects of rate increases
implemented over the past two years that were partially offset by adverse
development on prior year policies.
16
The consolidated expense ratios were 33.0% and 34.7% for the three months ended
September 30, 2003 and 2002, respectively. The consolidated expense ratios were
35.6% and 37.3% for the nine months ended September 30, 2003 and 2002,
respectively. The improvement in the expense ratios was due to increased
premiums volumes and cost containment.
The tax provision is the sum of the provision (benefit) on income before federal
income taxes, change in the deferred tax asset valuation allowance, and state
income tax expense. A deferred tax asset is recognized only to the extent there
is expected taxable income resulting from future reversals of existing taxable
temporary differences, changes in unrealized gains on our available for sale
investment securities and a tax planning strategy related to the unrecorded
gains on real estate we own. Future changes in the fair value of available for
sale investment securities are subject to market fluctuation as is the impact on
the related deferred tax valuation allowance and resulting income tax expense
(benefit). The income tax expense provision for the three months ended September
30, 2003 was $28.8 million, which includes the effect of the change in the
deferred tax asset valuation allowance primarily related to alternative minimum
taxes of $10.5 million.
Segment Results
As of September 30, 2003, the Company's operations include four on-going
business segments: excess and surplus lines, risk management (formerly specialty
workers' compensation), specialty commercial and public entity. In evaluating
the operating performance of its segments, the Company focuses on core
underwriting and investing results before the consideration of realized gains or
losses from the sales of investments. Realized investment gains (losses) are
reported as a component of the corporate and other segment, as decisions
regarding the acquisition and disposal of securities reside with the executive
management of Company and are not under the control of the individual business
segments.
Excess and Surplus Lines. The following table summarizes the excess and surplus
lines results of operations for the three and nine months ended September 30,
2003 and 2002.
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- -----------------------------
(in millions) 2003 2002 2003 2002
-------------- ------------- -------------- -------------
Gross written premiums $ 100.5 $ 83.0 $ 284.6 $ 173.7
============== ============= ============== =============
Earned premiums 75.3 39.9 209.9 99.5
Losses and loss adjustment expenses 45.4 24.7 127.6 62.4
Underwriting expense 22.2 12.2 63.2 32.7
-------------- ------------- -------------- -------------
Underwriting income 7.7 3.0 19.1 4.4
Interest income, net 4.0 2.8 11.5 7.6
-------------- ------------- -------------- -------------
Income before taxes $ 11.7 $ 5.8 $ 30.6 $ 12.0
============== ============= ============== =============
Combined ratio 89.7% 92.6% 90.9% 95.6%
============== ============= ============== =============
The increase in gross written premiums and earned premiums for the three months
ended September 30, 2003 was primarily attributable to rate increases on renewal
business. For the three months ended September 30, 2003, gross written premiums
derived from renewal business increased $18.8 million to $41.4 million. Gross
written premiums related to new business were comparable at $64.7 million for
the three months ended September 30, 2003, compared to $64.4 million for the
same period of 2002. For the nine months ended September 30, 2003, gross written
premiums derived from new business increased $83.4 million to $204.7 million.
Renewal gross written premiums increased $35.9 million to $96.8 million for the
nine months ended September 30, 2003, compared to $60.9 million for the same
period of 2002. The increase was primarily rate driven as the Company has not
changed the profile of policies it underwrites. Partially offsetting these
increases were cancellations and endorsements, which reduced gross written
premiums by approximately $5.6 million and $16.9 million for the three and nine
month ended September 30, 2003, respectively.
17
On March 31, 2003, Colony Insurance Group entered into a 15% quota share
reinsurance agreement with Houston Casualty Company, a subsidiary of HCC
Insurance Holdings, Inc. ("HCC"). Houston Casualty Company will, in turn, assume
15% of the losses from the excess and surplus lines segment. As of September 30,
2003, the Company ceded approximately $26.4 million of gross written premiums,
$7.5 million of earned premiums and $4.3 million of losses and loss adjustment
expenses. The Company receives a ceding commission to offset its acquisition
costs related to these premiums. As of September 30, 2003, the Company earned a
ceding commission of $1.5 million.
The excess and surplus lines segment's loss ratio improved to 60.2% and 60.8%
for the three and nine months ended September 30, 2003, respectively, compared
to 62.1% and 62.7% for the same periods in 2002. The improvement was primarily
the effects of rate increases realized over the past year. Loss reserves for the
excess and surplus lines were $258.2 million as of September 30, 2003, compared
to $159.9 million as of September 30, 2002.
The expense ratio for the three months ended September 30, 2003 was 29.5%
compared to 30.5% for the same period in 2002. The expense ratio for the nine
months ended September 30, 2003 was 30.1% compared to 32.9% for the same period
in 2002. Increases in variable expenses were offset by economies of scale
resulting from the increase in gross written premiums related to fixed expenses.
Increases in net investment income were the result of an increase in invested
assets due to positive cash flows over the past twelve months, combined with a
capital contribution of $12.0 million. Net invested assets increased to $483.9
million as of September 30, 2003, compared to $298.1 million as of September 30,
2002.
Risk Management (formerly Specialty Workers' Compensation). The following table
summarizes the results of operations for the risk management segment for the
three and nine months ended September 30, 2003 and 2002.
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- --------------------------
(in millions) 2003 2002 2003 2002
-------------- ------------- ------------ ------------
Gross written premiums $ 54.6 $ 61.6 $ 151.3 $ 161.7
============== ============= ============ ============
Earned premiums 31.7 26.3 95.7 80.9
Losses and loss adjustment expenses 22.7 18.5 80.7 66.9
Underwriting expense 13.1 11.4 49.7 36.3
-------------- ------------- ------------ ------------
Underwriting loss (4.1) (3.6) (34.7) (22.3)
Interest income, net 6.9 7.5 20.8 24.1
-------------- ------------- ------------ ------------
Income (loss) before taxes $ 2.8 $ 3.9 $ (13.9) $ 1.8
============== ============= ============ ============
Combined ratio 112.8% 112.9% 136.2% 127.6%
============== ============= ============ ============
Gross written premiums in the three months ended September 30, 2003 were $7.0
million lower than the same period in 2002. New business for the directly
written voluntary portion of the Company's business increased $3.3 million to
$19.7 million while renewal gross written premiums decreased $7.7 million as
compared to the same period in 2002, due to the Company's plan to discontinue
writing certain products. The remaining decrease was primarily comprised of $3.8
million less premium for a personal automobile program which the Company has
been exiting and $2.8 million return premium on retrospectively rated policies.
This was partially offset by $3.8 million of premium for directors and officer
coverage initiated in 2003. The $10.4 million decrease in gross written premiums
for the nine months ended September 30, 2003 as compared to the same period in
2002 included $16.1 million of increased new business, which was offset by $29.7
million of lower renewal premiums. Other factors increasing gross written
premiums in 2003 compared to 2002 included a $6.5 million increase in
involuntary pool premiums and $9.6 million in directors and officers premiums.
Other factors decreasing gross written premiums in 2003 compared to 2002
included reduced premiums related to the personal automobile program of $10.7
million and $1.4 million of retrospectively rated policy refunds. The greater
declines in renewal premium as compared to new business are due to the
restructuring of this segment discussed below.
18
The Company, through its subsidiary Argonaut Insurance Company, entered into an
agreement with Kemper Insurance Company ("Kemper") to purchase the renewal
rights for upper middle market national accounts. Under the terms of the
agreement, the Company has the right to acquire the assets and liabilities of
certain policies originally underwritten by Kemper. The Company has the option
to assume all losses and receive any unearned premiums, less commissions, on
accounts it selects. The Company has sole discretion as to which accounts it
will acquire, and is guaranteed at least one renewal of the policy. The Company
acquired these policies during the three month and nine month period ended
September 30, 2003. All unearned premiums acquired are being recognized as
income ratably over the remaining life of the policy. The Company entered into
this agreement in accordance with its previously announced plan to concentrate
on casualty risk management solutions for upper-middle market accounts. As part
of this focus, $6.7 million and $13.3 million of new business for the three and
nine months ended September 30, 2003 represents premium written under the
renewal rights agreement signed with Kemper in the spring of 2003.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share
reinsurance agreement with HCC. Under the terms of the agreement, the Company
will assume 3.33% of the losses under HCC's USA Directors and Officers Liability
program. Additionally, the Company will assume 5.0% of the losses under HCC's
International Directors and Officers Liability program. HCC will cede 3.33% and
5.0% of gross written premiums under each respective program to the Company. For
the three and nine months ending September 30, 2003, gross written premiums
recorded under this program totaled $3.8 million and $9.6 million, respectively.
The Company will pay to HCC ceding and other commissions to offset costs related
to these premiums. For the three and nine months ended September 30, 2003, the
Company expensed ceding and other commissions of $0.6 million and $1.1 million,
respectively.
Net earned premiums for the three and nine months ended September 30, 2003 were
$5.4 million and $14.8 million greater, respectively than the same periods in
2002. This three and nine month increase was primarily attributable to the
following factors: (a) larger volume of premiums on directly written voluntary
inforce business during the three and nine months ended September 30, 2003
produced $3.5 million and $6.5 million, respectively, (b) the assumption of
business underwritten by HCC accounted for $2.7 million and $4.2 million,
respectively, and (c) involuntary pool premium assumed was $0.9 million less and
$4.1 million more compared to the same periods in 2002.
Losses and loss adjustment expenses for the three and nine months ended
September 30, 2003 resulted in loss ratios of 71.5% and 84.3%, respectively,
compared to 70.0% and 82.7% for the same periods in 2002. The Company increased
its reserve for unallocated loss adjustment expenses by $1.6 million for the
quarter ended September 30, 2003 to reflect the higher rate of costs associated
with the costs needed to adjust claims. The loss ratio for the nine months ended
September 30, 2003 was also impacted by an increase to the allowance for
doubtful accounts for balances due from reinsurers of $5.0 million. In addition,
year to date results include $5.0 million of adverse development recognized in
the first quarter of 2003 attributable to one multi-year construction account
that was not renewed in January of 2003. Loss reserves totaled $655.5 million
and $604.6 million as of September 30, 2003 and 2002, respectively.
The expense ratios were 41.3% and 42.9% for the three months ended September 30,
2003 and 2002, respectively, with underwriting expenses being $1.7 million
higher in the three months ended September 30, 2003 as compared to the same
period in 2002. Deferred policy acquisition costs were $5.7 million higher for
the three months ended September 30, 2003, as compared to the same period in
2002. This increase in expense was primarily due to acquisition costs not being
recoverable and therefore expensed in the years prior to 2002. Offsetting this
was a reduction in other underwriting expenses of $3.5 million for the three
months ended September 30, 2003 compared to the same period in 2002, primarily
due to reduction in legal and occupancy expenses.
19
The expense ratios were 51.9% and 44.9% for the nine months ended September 30,
2003 and 2002, respectively. The increase in underwriting expenses of $13.4
million was due primarily to $1.6 million in restructuring charges for the nine
month period, combined with an increase in deferred policy acquisition costs of
approximately $13.4 million as discussed above.
In March 2003, Argonaut Insurance Company began to restructure its operations to
concentrate on casualty risk management solutions for upper-middle market
accounts. With the elimination of non-strategic products, Argonaut Insurance
Company has reduced its workforce by 67 employees as of September 30, 2003, and
anticipates the reduction of an additional two employees in 2004. Severance
costs of $0.9 million and outplacement and relocation costs of $0.3 million had
been recognized as of September 30, 2003. Additionally, the Company closed three
offices at a total cost of $0.3 million. The costs associated with the
restructuring are included in the underwriting, acquisition and insurance
expenses line item in the accompanying condensed consolidated statements of
operations. No material costs associated with the restructuring were incurred in
the third quarter of 2003.
The changes in investment income for the three and nine months ended September
30, 2003, as compared to the same periods in 2002, were primarily the result of
lower investment yields partially offset by an increase in invested assets due
to positive cash flows. Invested assets were $678.1 million as of September 30,
2003, compared to $635.9 million as of September 30, 2002.
Specialty Commercial. The following table summarizes the specialty commercial
results of operations for the three and nine months ended September 30, 2003 and
2002.
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- --------------------------
(in millions) 2003 2002 2003 2002
-------------- ------------- ------------ ------------
Gross written premiums $ 39.7 $ 35.1 $ 109.7 $ 95.0
============== ============= ============ ============
Earned premiums 31.9 27.1 90.1 77.8
Losses and loss adjustment expenses 23.0 18.5 65.1 54.0
Underwriting expense 8.8 8.1 26.2 23.8
-------------- ------------- ------------ ------------
Underwriting income (loss) 0.1 0.5 (1.2) -
Interest income, net 2.4 2.5 7.1 7.5
-------------- ------------- ------------ ------------
Income before taxes $ 2.5 $ 3.0 $ 5.9 $ 7.5
============== ============= ============ ============
Combined ratio 99.9% 98.0% 101.3% 100.0%
============== ============= ============ ============
The increase in gross written premiums and earned premiums was primarily
attributable to rate increases on renewal business. Renewal premiums increased
from $26.1 million for the three months ended September 30, 2002 to $34.5
million for the same period in 2003. Renewal premiums for the nine months ended
September 30, 2003 were $88.1 million compared to $72.3 million for the same
period in 2002. The increases in renewal premiums were primarily due to average
rate increases of approximately 8%. Premiums related to new business written
decreased to $5.2 million for the three months ended September 30, 2003 from
$9.0 million for the same period in 2002. Premiums related to new business were
$21.6 million for the nine months ended September 30, 2003, compared to $22.7
million for the same period in 2002.
20
The specialty commercial segment's loss ratios were 72.2% and 72.3% for the
three and nine months ended September 30, 2003, respectively, compared to 68.0%
and 69.4% for the same periods in 2002. During the three month period ended
September 30, 2003, the specialty commercial segment incurred approximately $1.9
million in catastrophe losses due primarily to food spoilage resulting from the
power outage that affected the northeastern United States in August 2003. For
the nine months ended September 30, 2003, this segment reported total
catastrophe losses of $4.0 million, compared to $2.4 million for the same period
in 2002. Catastrophe losses accounted for 6.1 and 4.5 points of the loss ratios
for the three and nine months ended September 30, 2003, respectively. The
specialty commercial segment's loss reserves were $181.0 million and $165.5
million as of September 30, 2003 and 2002, respectively.
The expense ratios for the specialty commercial segment were 27.7% and 29.0% for
the three and nine months ended September 30, 2003, respectively, compared to
30.0% and 30.6% for the same periods in 2002. The continued improvement in the
expense was primarily the result of increased premium volumes and cost
containment.
The changes in investment income for the three and nine months ended September
30, 2003, as compared to the same periods in 2002, were primarily the result of
lower investment yields partially offset by an increase in invested assets due
to positive cash flows. Invested assets were $266.5 million as of September 30,
2003, compared to $241.0 million as of September 30, 2002.
Public Entity. The following table summarizes the results of operations for the
public entity segment for the three and nine months ended September 30, 2003 and
2002.
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- --------------------------
(in millions) 2003 2002 2003 2002
-------------- ------------- ------------ ------------
Gross written premiums $ 25.3 $ 10.1 $ 48.0 $ 18.8
============== ============= ============ ============
Earned premiums 9.2 3.0 21.4 6.7
Losses and loss adjustment expenses 5.6 1.9 13.5 4.6
Underwriting expense 2.7 1.1 6.7 2.5
-------------- ------------- ------------ ------------
Underwriting (loss) income 0.9 - 1.2 (0.4)
Interest income, net 0.2 0.1 0.5 0.4
-------------- ------------- ------------ ------------
Income before taxes $ 1.1 $ 0.1 $ 1.7 $ -
============== ============= ============ ============
Combined ratio 89.9% 101.5% 94.6% 106.8%
============== ============= ============ ============
The increase in gross written premiums and earned premiums was primarily the
result of new business written in 2003. For the three and nine months ended
September 30, 2003, the public entity segment's new business was approximately
$12.0 million and $25.8 million respectively. Additionally, the segment wrote
$13.3 million and $22.2 million of renewal business for the three and nine month
periods ended September 30, 2003. Premium volume for the public entity sector
tends to be seasonal in the period from July through October, which corresponds
with a typical insured's fiscal year end.
Losses and loss adjustment expenses for the three and nine months ended
September 30, 2003 resulted in a loss ratio of 60.0% and 62.9% compared to 66.3%
and 68.6% for the same periods in 2002. The decrease in the loss ratio is
attributable to increased rates as well as the maturation of the segment's
business. In addition, favorable development from prior years' reserves
contributed to the decrease in the loss ratio. Loss reserves for the public
entity segment were $23.3 million and $12.2 million as of September 30, 2003 and
2002, respectively.
The expense ratios for the three months and nine months ended September 30, 2003
were 29.9% and 31.6%, respectively, compared to 35.2% and 38.2%, respectively,
for the same periods in 2002. The decrease in the expense ratios primarily
resulted from operational efficiencies gained from increased premium volume.
21
Run-off Lines. The Company has discontinued active underwriting of certain lines
of business. The Company is still obligated to pay losses incurred on these
lines which include general liability, asbestos and environmental liabilities
and medical malpractice policies written in past years. The lines currently in
run-off are characterized by long elapsed periods between the occurrence of a
claim and any ultimate payment to resolve the claim. The Company utilizes a
specialized staff dedicated to administer and settle these claims. Loss reserves
for the run-off lines were as follows:
September 30,
--------------------------------------------
2003 2002
--------------------- ---------------------
(in millions) Gross Net Gross Net
---------- ---------- ---------- ----------
Environmental and asbestos:
Loss reserves, beginning of the period $236.5 $178.3 $168.2 $130.7
Incurred losses 0.5 10.1 8.6 7.8
Losses paid 8.2 6.8 18.5 9.3
---------- ---------- ---------- ----------
Loss reserves - environmental and
asbestos, end of the period 228.8 181.6 158.3 129.2
Other run-off lines 53.0 43.0 63.0 51.3
Net reserves ceded - retroactive
reinsurance contract - (42.3) - -
---------- ---------- ---------- ----------
Total reserves - run-off lines $281.8 $182.3 $221.3 $180.5
========== ========== ========== ==========
In the third quarter of 2003, the Company completed an analysis of the
recoverability of losses and loss adjustment expense reserves related to
asbestos and environmental claims for its run-off lines. This analysis resulted
in a decrease to ceded loss and loss adjustment expense reserves, and a
corresponding increase to net loss and loss adjustment expense reserves and a
related expense of $10.2 million. The Company revised itsr analysis that
projects anticipated future ceded reinsurance recoveries relative to existing
claims and incurred but not reported claims. The analysis relied on
identification of reinsurance contracts that the Company purchased at the time
the policies were in force. These reinsurance contracts provide coverage for
specific policy contracts for which the Company has claim exposure. Previously,
the Company utilized historical relationships of ceded losses to gross losses to
estimate expected future ceded losses. The current approach incorporates more of
the specific characteristics of the existing and expected claims, and related
policies and reinsurance contracts, and, accordingly, management believes it
provides a more refined estimate of expected future ceded loss recoveries. The
analysis and reserve changes are for policies primarily written from 1970 to the
mid-1980s, at which point the Company generally began excluding asbestos
coverage from its insurance contracts.
Goodwill
The Company reviewed goodwill of approximately $27.1 million allocated to the
risk management segment, due to the restructuring of Argonaut Insurance Company
combined with the sale of the real estate holdings during the three months ended
March 31, 2003. No impairment of the goodwill balances was indicated. However,
operating losses within the risk management segment could result in an
impairment of the goodwill assigned to this reporting unit, resulting in a write
down of the goodwill in future periods. The Company will conduct its annual
review of goodwill impairment prior to the end of 2003.
Reinsurance
Certain of the Company's reinsurance carriers have experienced deteriorating
financial condition or have been downgraded by rating agencies. Amounts due on
paid loss recoverables and case reserves totaled $22.1 million. Amounts due on
incurred but not reported claims totaled $23.1 million. Through the date of this
filing, the reinsurers have not defaulted on their obligations to pay claims due
to the Company. The aforementioned reinsurance balances recoverable are
primarily due from insurance subsidiaries of Trenwick Group Ltd., which
announced in August 2003 its intent to restructure its operations under the U.S.
Bankruptcy Code. The balances are due from regulated insurance subsidiaries,
which have not filed for bankruptcy protection, not the parent corporation
Trenwick Group Ltd.
23
The Company will continue to monitor these reinsurers; however, to date, the
Company has not received any indication that the reinsurers will fail to honor
their obligations under the reinsurance agreements. It is possible that future
financial deterioration of such reinsurers could result in the uncollectibility
of certain balances and therefore impact the financial results of the Company.
At present, the Company carries a reserve of $20.9 million as an estimate of the
amount of uncollectable reinsurance. Management will continue to monitor the
collectibility of reinsurance balances recoverable and adjust this reserve as
appropriate. It is possible that future financial deterioration of reinsurers
could result in the uncollectibility of additional balances and therefore impact
the Company's financial results.
Liquidity and Capital Resources
The Company's principal operating cash flow sources are premiums and investment
income. The primary operating cash outflows are for claim payments and operating
expenses.
For the nine months ended September 30, 2003, consolidated net cash provided by
operating activities was $129.8 million, compared to $51.8 million for the same
period in 2002. The increase in cash inflows was primarily attributable to
increased premium writings. The Company also holds marketable investment
securities of approximately $1,438.1 million that could be sold to cover
liquidity.
On May 15, 2003, Argonaut Group Statutory Trust, a Connecticut statutory trust
and wholly-owned subsidiary of the Company, sold 15,000 Floating Rate Capital
Securities (liquidation amount $1,000 per Capital Security) to I-Preferred Term
Securities II, Ltd. in a private sale for $15.0 million. The Trust used the
proceeds from this sale, together with the proceeds from its sale of Common
Securities to the Company, to buy a series of Floating Rate Junior Subordinated
Deferrable Interest Debentures due 2033 from the Company. The Debentures have
the same payment terms as the Capital Securities.
The interest rate on the Debentures and the Capital Securities is equal to
3-Month LIBOR plus 4.10% (not to exceed 12.5%), which rate is reset quarterly.
The Debentures are unsecured and are subordinated in right of payment to all of
the Company's future senior indebtedness. Beginning in May 2008, the Company
will have the right to redeem the Debentures, in whole or in part, at a price
equal to 100% of the principal amount of the Debentures, plus accrued and unpaid
interest to the date of redemption. The Company also has the right to redeem all
of the Debentures before May 2008 upon the happening of specified events at a
price equal to 107.5% of the principal amount of the Debentures, plus accrued
and unpaid interest to the date of redemption.
On May 7, 2003, the Company received a waiver from HCC of the requirement to use
the proceeds from the issuance of the Debentures to repay the HCC note. The
Company used $12.0 million of the net proceeds from the sale of the Debentures
to increase the statutory capital of its insurance company subsidiaries.
On November 3, 2003, the Company sold 4.8 million shares of its common stock,
par value $0.10 per share, in an underwritten public offering. The sale was made
pursuant to an Underwriting Agreement, dated October 28, 2003, by and among the
Company and Raymond James & Associates, Inc., as representative of the
underwriters. The common stock was issued at a price of $15.80 per share, less
an underwriting discount of 5.5%. The net proceeds from the sale of the common
stock were approximately $70.9 million, after deducting the underwriting
discounts and commissions and offering expenses. The Company intends to
contribute substantially all of the net proceeds from this offering to its
insurance subsidiaries to support the continued growth of the business, improve
the regulatory capital adequacy ratios and maintain strong financial strength
ratings. The remainder of the net proceeds will be used for general corporate
purposes. The Company has also granted the underwriters an option to purchase an
additional 720,000 shares of common stock to cover over-allotments.
23
Concurrent with the closing of the underwritten public offering, HCC purchased
from the Company in a private placement 533,173 shares of the Company's common
stock at a price of $14.931 per share, which was equal to the public offering
price in the underwritten public offering less the underwriting discount. The
Company used the proceeds from this private placement to repay approximately
$7.9 million of the $12.0 million aggregate remaining principal amount of a note
payable to HCC, plus accrued interest on that portion of the note.
Each of the Company's insurance subsidiaries is currently undergoing a triennial
examination by the insurance regulator of the state in which it is domiciled.
The Company has not been notified of any proposed adjustments to its statutory
capital. No assurances can be given, however, that the triennial review will not
result in material changes to the Company's statutory capital.
Refer to Part I, Item 7 - "Management's Discussion and Analysis of Operating
Results and Financial Condition - Liquidity" in the Company's Annual Report on
Form 10-K/A for the year ended December 31, 2002 that the Company filed with the
Securities and Exchange Commission on July 24, 2003 for further discussion on
the Company's liquidity.
Recent Accounting Pronouncements and Significant Accounting Policies
New Accounting Pronouncements
The discussion of the adoption and pending adoption of recently issued
accounting policies is included in "Note 2 - Recently Issued Accounting
Pronouncements" in the Notes to the Condensed Financial Statements, included in
Item 1.
Critical Accounting Policies
Refer to "Critical Accounting Policies" in the Company's Annual Report on Form
10-K/A for the year ended December 31, 2002 that the Company filed with the
Securities and Exchange Commission on July 24, for information on accounting
policies that the Company considers critical in preparing its consolidated
financial statements. These policies include significant estimates made by
management using information available at the time the estimates were made.
However, these estimates could change materially if different information or
assumptions were used.
Item 3. Market Risks
The primary market risk exposures that result in an impact to the investment
portfolio relate to equity price changes and interest rate changes. The Company
does not hold any derivative instruments.
The Company has an exposure to foreign currency risks in conjunction with the
reinsurance agreement with HCC. Accounts under the International Directors &
Officers Liability Quota Share program may settle in the following currencies:
U.S dollars, British pounds, Canadian dollars or Euros. Remittances are due
within 60 days of quarter end, one quarter in arrears. Due to the extended time
frame for settling the accounts plus the fluctuation in currency exchange rates,
the potential exists for the Company to realize gains and or losses related to
the exchange rates. As of September 30, 2003, the Company has not received
payment on this contract; therefore, no foreign currency gains or losses have
been recognized to date. Management is unable at this time to estimate the
future gain or losses, if any.
24
The Company holds a well-diversified portfolio of investments in common stocks
representing U.S. firms in industries and market segments ranging from small
market capitalization stocks to the Standard & Poors 500 stocks. Equity price
risk is managed primarily through the monitoring of funds committed to the
various types of securities owned and by limiting the exposure in any one
investment or type of investment. During the third quarter of 2003, the Company
sold approximately 445,900 shares of its investment in Curtiss-Wright Corp. and
realized pre-tax gains of approximately $25.1 million. Additionally, during the
third quarter of 2003, the Company reduced its investment in other equity
securities by approximately $56.9 million and realized pre-tax gains of
approximately $23.4 million on such sales.
The Company's primary exposure to interest rate risk relates to its fixed
maturity investments including redeemable preferred stock. Changes in market
interest rates directly impact the market value of the fixed maturity securities
and redeemable preferred stocks. Some fixed income securities have call or
prepayment options. This subjects the Company to reinvestment risk if issuers
call their securities and Argonaut Group reinvests the proceeds at lower
interest rates.
Exposure to interest rate risk is managed by adhering to specific guidelines in
connection with the investment portfolio. The Company primarily invests in high
investment grade bonds ("AAA" rated U.S. treasury notes and government agencies
and "A" or better rated municipal bonds, corporate bonds and preferred stocks).
Less than 1.0% of the fixed income portfolio is invested in bonds rated lower
than "BBB", with a 20-year maximum effective maturity. During the three and nine
months ended September 30, 2003, the Company recognized other than temporary
losses on the investment portfolio of $0.2 million and $4.0 million,
respectively. During the three and nine months ended September 30, 2002, the
Company recognized other than temporary losses on the investment portfolio of
$4.2 million.
Management has assessed these risks and believes that there have been no
material changes since December 31, 2002.
Item 4. Controls and Procedures
In connection with the filing of this Form 10-Q, management, including the
Company's chief executive officer and chief financial officer, has reviewed the
effectiveness of the Company's disclosure controls and procedures designed to
ensure that material information relating to the Company and its consolidated
subsidiaries is made known to management by others within such consolidated
subsidiaries. Based on the evaluation, management, including the Company's chief
executive officer and chief financial officer, concluded that the Company's
disclosure controls and procedures were effective as of September 30, 2003.
There have been no changes in the Company's internal controls over financial
reporting during the three months ended September 30, 2003 that were identified
in connection with the evaluation referred to above that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
25
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
Argonaut Insurance Company v. Los Angeles Metropolitan Transit Authority
("MTA"). The trial judge for the MTA litigation has postponed the trial of the
first stage of this case before a three-judge panel from the third quarter of
2003 to the second quarter of 2004. That trial will primarily consider a portion
of Argonaut Insurance Company's counterclaim for sums it contends are due to it
from the MTA.
Refer to Part I, Item 3 - "Legal Proceedings" in the Company's Annual Report on
Form 10-K/A for the year ended December 31, 2002 that the Company filed with the
Securities and Exchange Commission on July 24, 2003 for the year ended December
31, 2002 for additional discussion on the Company's pending legal proceedings.
Item 2. Changes in Securities and Use of Proceeds
Refer to Part II, Item 2 - "Changes in Securities and Use of Proceeds" in the
Company's Quarterly Report on Form 10-Q for the three months ended March 31,
2003 for discussion on the Company's issuance of Series A Mandatory Convertible
Preferred Stock.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
A list of exhibits filed herewith is contained on the Exhibit Index
immediately preceding such exhibits and is incorporated herein by
reference.
(b) Reports on Form 8-K
On July 7, 2003, the Company filed a current report on Form 8-K that
included the consent of Ernst & Young LLP with respect to various
registration statements on Form S-8 relating to the Company's employee
benefit plans.
On August 6, 2003, the Company furnished a current report on Form 8-K
under Item 12 on Form 8-K announcing its operating results for the three
and six months ended June 30, 2003. This current report on Form 8-K shall
not be deemed to be incorporated by reference into this quarterly report
on Form 10-Q.
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Argonaut Group, Inc.
(Registrant)
/s/ Mark E. Watson III
- ---------------------------
Mark E. Watson III
Chief Executive Officer and President
(principal executive officer)
/s/ Mark W. Haushill
- ---------------------------
Mark W. Haushill
Chief Financial Officer, Vice President and Treasurer
(principal financial and accounting officer)
/s/ Byron L. LeFlore, Jr.
- ---------------------------
Byron L. LeFlore, Jr.
General Counsel, Vice President and Secretary
November 14, 2003
27
EXHIBIT INDEX
Exhibit
No. Description
10.1 Promissory Note, dated November 3, 2003, in the principal amount
of $4,118,014 payable by Argonaut Group, Inc. to HCC Insurance
Holdings, Inc.
31.1 Certificate of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31.2 Certificate of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32 Certificate of the Chief Executive Officer and the Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
EXHIBIT 10.1
PROMISSORY NOTE
$4,118,014 November 3, 2003
FOR VALUE RECEIVED, the undersigned, ARGONAUT GROUP, INC., a Delaware
corporation having its principal office at Suite 800, 10101 Reunion Place, San
Antonio, Texas 78216 ("Borrower"), hereby promises to pay to the order of HCC
INSURANCE HOLDINGS, INC., a Delaware corporation having its principal office at
13403 Northwest Freeway, Houston, Texas 77040 ("Lender"), the principal amount
of FOUR MILLION ONE HUNDRED EIGHTEEN THOUSAND FOURTEEN DOLLARS ($4,118,014),
together with interest on the unpaid balance hereof, commencing from the date
hereof.
This Promissory Note replaces in its entirety and supersedes (but does
not, other than with respect to the principal amount previously paid by the
Borrower, cancel or extinguish the indebtedness evidenced by) that certain
Promissory Note dated March 31, 2003, executed by Borrower and payable to the
order of Lender, in the original amount of $18,000.000.
The further terms and conditions of this Promissory Note are as
follows:
SECTION 1. Defined Terms. The following terms (whether or not underscored) when
used in this Promissory Note and not otherwise defined herein shall, except
where the context otherwise requires, have the following meanings (such meanings
to be equally applicable to the singular and plural forms thereof):
"Borrower" is defined in the first paragraph.
"Business Day" means any day which is neither a Saturday or Sunday nor
a legal holiday on which banks are authorized or required to be closed in Texas.
"Change of Control" means the acquisition by any Person, or two or more
Persons acting in concert, of beneficial ownership (within the meaning of Rule
13d-3 of the Securities and Exchange Commission under the Securities Exchange
Act of 1934) of 50% or more of the outstanding shares of voting stock of the
Borrower.
"herein", "hereof", "hereto", "hereunder" and similar terms contained
in this Promissory Note refer to this Promissory Note as a whole and not to any
particular Section, paragraph or provision of this Promissory Note.
"Interest Payment Date" is defined in Section 4.
"Lender" is defined in the first paragraph.
"Maturity Date" means March 31, 2006.
"Person" means any natural person, corporation, firm, association,
government, governmental agency or any other entity, whether acting in an
individual, fiduciary or other capacity.
Subsidiary" means, with respect to any Person, any corporation of which
more than 50% of the outstanding capital stock having ordinary voting power to
elect a majority of the board of directors of such corporation (irrespective of
whether at the time capital stock of any other class or classes of such
corporation shall or might have voting power upon the occurrence of any
contingency) is at the time directly or indirectly owned by such Person, by such
Person and one or more other Subsidiaries of such Person, or by one or more
other Subsidiaries of such Person.
SECTION 2. Interest. Interest shall accrue from October 1, 2003 or the most
recent date for which interest has been paid or duly provided for. Interest
shall be payable at the rate of 12% per annum. Following the maturity (whether
by demand, acceleration or otherwise) of this Promissory Note, interest shall
accrue and be payable at the rate of 15% per annum. Interest shall be calculated
on the basis of a 360-day year. Notwithstanding the foregoing, the interest rate
shall not exceed the maximum rate of interest permitted by law.
SECTION 3. Principal. The entire unpaid principal balance hereof, together with
all accrued and unpaid interest, shall be due and payable in full on the
Maturity Date. The indebtedness evidenced hereby is senior to all other
indebtedness of the Borrower other than indebtedness to banks or financial
institutions for borrowed money that is not designated as subordinated to senior
indebtedness.
SECTION 4. Interest Payments. Accrued interest shall be payable on (i) the last
Business Day of each March, June, September and December after the date hereof
and preceding the Maturity Date (such day herein called a "Interest Payment
Date"),(ii) at maturity (whether by demand or otherwise), and (iii) on demand
after maturity. Payments of both principal and interest are to be made to an
account designated by Lender (and as to which Lender has notified Borrower) in
lawful money of the United States of America in same day or immediately
available funds.
SECTION 5. Optional Prepayments. Borrower may, at any time and from time to time
on any Business Day upon at least three but no more than five Business Days'
prior written notice (which shall be irrevocable) to Lender, without penalty or
premium, make voluntary prepayments of the outstanding principal amount of this
Promissory Note in a minimum aggregate amount of $1,000,000 (together with all
accrued and unpaid interest on the amount prepaid).
SECTION 6. Mandatory Prepayment. The Borrower shall immediately, without notice
or demand and without penalty or premium, prepay the outstanding principal
amount of this Promissory Note in an amount equal to the amount of any proceeds
resulting from (i) indebtedness for borrowed money with a maturity (including
resulting from trust preferred securities) exceeding one year incurred by the
Borrower or any of its subsidiaries after the date hereof to the extent
exceeding $1,000,000 in the aggregate (it being understood that any such
mandatory prepayment required by any transaction involving a subsidiary of
Borrower shall be subject to any necessary regulatory approvals); and (ii) the
issuance of any Series A Mandatory Convertible Preferred Stock to any person
other than Lender or any of its affiliates.
SECTION 7. Covenants.
---------
(a) Borrower shall preserve its existence as a Delaware corporation in good
standing and shall be and Borrower and its subsidiaries shall remain
qualified to do business in good standing in all states and countries
in which it is required to be so qualified.
(b) Borrower shall make all filings required to be made by it under the
Securities Exchange Act of 1934 on a timely basis.
(c) Borrower shall use its reasonable best efforts to maintain the
quotation of the Common Shares on the Nasdaq National Market or to list
the Common Shares on the New York Stock Exchange or another national
securities exchange.
SECTION 8. Events of Default. In case any one or more of the following events of
default (each an "Event of Default") shall occur and shall not have been
remedied:
(a) failure to pay when due any payment of interest or principal due under
this Promissory Note, if and only if such payment shall not have been
made within five (5) days of the due date;
(b) breach by Borrower of any covenant of Borrower contained in this
Promissory Note or in the Subscription Agreement, dated as of March 12,
2003 and amended as of March 31, 2003, between Borrower and Lender, if
and only if such breach shall not have been cured by Borrower within
thirty (30) days after written notice thereof has been delivered to
Borrower;
(c) the failure to pay when due any payment of interest or principal due
under any agreement of Borrower or any of its subsidiaries relating to
any indebtedness for borrowed money in excess of $1,000,000, if and
only if such failure to pay shall not have been cured by Borrower
within thirty (30) days after the due date;
(d) the occurrence of a Change of Control;
(e) there shall occur a material adverse change in the business or results
of operations of the Borrower and its subsidiaries, taken as a whole;
(f) if a final judgment for the payment of money in excess of the sum of
$500,000 (or with respect to property with a value in excess of such
amount) shall be rendered against the Borrower and such judgment shall
remain unsatisfied for a period of 30 consecutive days after the entry
thereof and within such 30-day period, such judgment has not been (a)
stayed pending appeal or (b) discharged;
(g) if the Borrower takes any action that is intended to result in its
termination, dissolution or liquidation; or
(h) if the Borrower shall (i) have an order of relief entered in any
proceeding filed by it under the federal bankruptcy laws; (ii) admit
its inability to pay its debts generally as they become due; (iii) make
a general assignment for the benefit of creditors; (iv) file a
petition, or admit the material allegations of any petition filed
against it, in bankruptcy under the federal bankruptcy laws, or under
any law for the relief of debtors, or for the discharge, arrangement or
compromise of their debts; or (v) consent to the appointment of a
receiver, conservator, trustee or liquidator of all or part of its
assets.
Upon the occurrence of any Event of Default hereunder or default under any other
agreement or instrument securing or assuring the payment of this Note, then in
any such event the holder hereof may, at its option, (i) declare the entire
unpaid balance of the Note to be immediately due and payable without presentment
or notice of any kind which Borrower waives pursuant to Section 11 herein, (ii)
reduce any claim to judgment, and/or (iii) pursue and enforce any of Lender's
rights and remedies available pursuant to any applicable law or agreement;
provided, however, in the case of any default of this Note without any notice to
Borrower or any other act by Lender, this Note shall become immediately due and
payable without presentment, demand, protest, or other notice of any kind, all
of which are hereby waived by Borrower.
SECTION 9. Costs and Expenses. Borrower shall reimburse Lender or any other
holder hereof for all costs incurred by it (including reasonable attorneys'
fees) in the enforcement or collection of any amounts due under this Promissory
Note. Borrower shall indemnify and hold Lender (and each of its officers,
directors, employees and agents) harmless from and against all losses, claims,
damages, costs and expenses arising from the loans evidenced by this Promissory
Note.
SECTION 10. No Waiver. No waiver by Lender of any of its rights or remedies
hereunder or under any other document evidencing or securing this Note or
otherwise, shall be considered a waiver of any other subsequent right or remedy
of Lender; no delay or omission in the exercise or enforcement by Lender of any
rights or remedies shall ever be construed as a waiver of any right or remedy of
Lender; and no single or partial exercise or enforcement of any such rights or
remedies shall ever be held to exhaust any right or remedy of Lender. The
remedies provided for herein are cumulative and are not exclusive of any
remedies that may be available to the Lender at law, in equity or otherwise.
Borrower and each surety, endorser, guarantor, and other party ever liable for
payment of any sums of money payable upon this Note, jointly and severally waive
presentment, demand, protest, notice of protest and non-payment or other notice
of default, notice of acceleration, and intention to accelerate, or other notice
of any kind, and agree that their liability under this Note shall not be
affected by any renewal or extension in the time of payment hereof, or in any
indulgences, or by any release or change in any security for the payment of this
Note, and hereby consent to any and all renewals, extensions, indulgences,
releases, or changes, regardless of the number of such renewals, extensions,
indulgences, releases, or changes.
SECTION 11. Notices. All notices or other communications which are required or
permitted hereunder shall be sufficiently given if in writing and personally
delivered or sent by registered or certified mail, postage prepaid, return
receipt requested, addressed to Borrower, Lender or other holder hereof, as the
case may be, at the respective addresses set forth in the first paragraph of the
Promissory Note, or to such other address as Borrower, Lender or such other
holder shall have given notice of pursuant hereto.
SECTION 12. Governing Law. THIS PROMISSORY NOTE SHALL BE GOVERNED BY AND
CONSTRUED IN ACCORDANCE WITH THE INTERNAL LAWS OF THE STATE OF TEXAS.
SECTION 13. Forum Selection and Consent to Jurisdiction. ANY LITIGATION BASED
HEREON, OR ARISING OUT OF, UNDER, OR IN CONNECTION WITH, THIS PROMISSORY NOTE,
OR ANY COURSE OF CONDUCT, COURSE OF DEALING, STATEMENTS (WHETHER ORAL OR
WRITTEN) OR ACTIONS OF LENDER OR BORROWER SHALL BE BROUGHT AND MAINTAINED
EXCLUSIVELY IN THE COURTS OF THE STATE OF TEXAS OR IN THE UNITED STATES DISTRICT
COURT FOR THE SOUTHERN DISTRICT OF TEXAS. BORROWER HEREBY EXPRESSLY AND
IRREVOCABLY SUBMITS TO THE JURISDICTION OF THE COURTS OF THE STATE OF TEXAS AND
OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF TEXAS FOR THE
PURPOSE OF SUCH LITIGATION AS SET FORTH ABOVE AND IRREVOCABLY AGREES TO BE BOUND
BY ANY JUDGMENT RENDERED THEREBY IN CONNECTION WITH SUCH LITIGATION. BORROWER
FURTHER IRREVOCABLY CONSENTS TO THE SERVICE OF PROCESS BY REGISTERED MAIL,
POSTAGE PREPAID, OR BY PERSONAL SERVICE WITHIN OR WITHOUT THE STATE OF TEXAS.
BORROWER HEREBY EXPRESSLY AND IRREVOCABLY WAIVES, TO THE FULLEST EXTENT
PERMITTED BY LAW, ANY OBJECTION WHICH IT MAY HAVE OR HEREAFTER MAY HAVE TO THE
LAYING OF VENUE OF ANY SUCH LITIGATION BROUGHT IN ANY SUCH COURT REFERRED TO
ABOVE AND ANY CLAIM THAT ANY SUCH LITIGATION HAS BEEN BROUGHT IN AN INCONVENIENT
FORUM. TO THE EXTENT THAT BORROWER HAS OR HEREAFTER MAY ACQUIRE ANY IMMUNITY
FROM JURISDICTION OF ANY COURT OR FROM ANY LEGAL PROCESS (WHETHER THROUGH
SERVICE OR NOTICE, ATTACHMENT PRIOR TO JUDGMENT, ATTACHMENT IN AID OF EXECUTION
OR OTHERWISE) WITH RESPECT TO ITSELF OR ITS PROPERTY, BORROWER HEREBY
IRREVOCABLY WAIVES SUCH IMMUNITY IN RESPECT OF ITS OBLIGATIONS UNDER THIS
PROMISSORY NOTE.
SECTION 14. Waiver of Jury Trial. LENDER AND BORROWER HEREBY KNOWINGLY,
VOLUNTARILY AND INTENTIONALLY WAIVE ANY RIGHTS THEY MAY HAVE TO A TRIAL BY JURY
IN RESPECT OF ANY LITIGATION BASED HEREON, OR ARISING OUT OF, UNDER, OR IN
CONNECTION WITH, THIS PROMISSORY NOTE, OR ANY COURSE OF CONDUCT, COURSE OF
DEALING, STATEMENTS (WHETHER ORAL OR WRITTEN) OR ACTIONS OF LENDER OR BORROWER.
BORROWER ACKNOWLEDGES AND AGREES THAT IT HAS RECEIVED FULL AND SUFFICIENT
CONSIDERATION FOR THIS PROVISION AND THAT THIS PROVISION IS A MATERIAL
INDUCEMENT FOR LENDER MAKING THE LOANS EVIDENCED BY THIS PROMISSORY NOTE.
ARGONAUT GROUP, INC.
/s/ Mark E. Watson III
------------------------------------
Name: Mark E. Watson III
Title: President and Chief Executive
Officer
EXHIBIT 31.1
CERTIFICATE OF COMPLIANCE
I, Mark E. Watson III, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Argonaut
Group, Inc;
2. Based on my knowledge, this report does not contain any untrue
statements of material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other
financial information included in this report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this report;
4. The registrant's other certifying officer and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) for the registrant and have:
a. Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
b. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report
based on such evaluation; and
c. Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has
materially affected, or is reasonably likely to materially affect,
the registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed,
based on our most recent evaluation of internal control over
financial reporting, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons
performing the equivalent functions):
a. All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information;
and
b. Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
CERTIFIED this 14th day of November, 2003.
/s/ Mark E. Watson III
------------------------------------
Mark E. Watson III
President and Chief Executive Officer
EXHIBIT 31.2
CERTIFICATE OF COMPLIANCE
I, Mark W. Haushill, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Argonaut
Group, Inc;
2. Based on my knowledge, this report does not contain any untrue
statements of material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other
financial information included in this report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this report;
4. The registrant's other certifying officer and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) for the registrant and have:
a. Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
b. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report
based on such evaluation; and
c. Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has
materially affected, or is reasonably likely to materially affect,
the registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed,
based on our most recent evaluation of internal control over
financial reporting, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons
performing the equivalent functions):
a. All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information;
and
b. Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
CERTIFIED this 14th day of November, 2003.
/s/ Mark W. Haushill
-----------------------------------
Mark W. Haushill
Vice President
Chief Financial Officer and Treasurer
EXHIBIT 32
CERTIFICATION OF COMPLIANCE WITH SECTION 906
SARBANES-OXLEY ACT OF 2002
I, Mark E. Watson III, President and Chief Executive Officer of Argonaut Group,
Inc. (the "Company") hereby certify in connection with the Quarterly Report on
Form 10-Q for the three and nine months ended September 30, 2003 ("the Report")
that:
1. The Report fully complies with the requirements of Section 13(a) of the
Securities Exchange Act of 1934; and
2. The information in the Report fairly presents, in all material
respects, the financial condition and results of operations of the
Company.
CERTIFIED this 14th day of November, 2003.
/s/ Mark E. Watson III
------------------------------------
Mark E. Watson III
President and Chief Executive Officer
EXBIBIT 32
CERTIFICATION OF COMPLIANCE WITH SECTION 906
SARBANES-OXLEY ACT OF 2002
I, Mark W. Haushill, Vice President, Chief Financial Officer and Treasurer of
Argonaut Group, Inc. (the "Company") hereby certify in connection with the
Quarterly Report on Form 10-Q for the three and nine months ended September 30,
2003 ("the Report") that:
1. The Report fully complies with the requirements of Section 13(a) of the
Securities Exchange Act of 1934; and
2. The information in the Report fairly presents, in all material
respects, the financial condition and results of operations of the
Company.
CERTIFIED this 14th day of November, 2003.
/s/ Mark W. Haushill
------------------------------------
Mark W. Haushill
Vice President
Chief Financial Officer and Treasurer