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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 March 31, 2004
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 May 6, 2004
Title Outstanding
Common Stock, par value $0.10 per share 27,613,563
ARGONAUT GROUP, INC.
TABLE OF CONTENTS
Page No.
Part I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
March 31, 2004 and December 31, 2003...................... 3
Condensed Consolidated Statements of Operations
Three months ended March 31, 2004 and 2003................ 4
Condensed Consolidated Statements of Comprehensive Income
Three months ended March 31, 2004 and 2003................ 5
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 2004 and 2003................ 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. Qualitative and Quantitative Disclosure About Market Risk.... 23
Item 4. Controls and Procedures...................................... 24
Part II. OTHER INFORMATION:
Item 1. Legal Proceedings............................................. 25
Item 2. Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities........................... 25
Item 3. Default Upon Senior Securities................................ 25
Item 4. Submission of Matters to a Vote of Security Holders........... 25
Item 5. Other Information............................................. 25
Item 6. Exhibits and Reports on Form 8-K ............................ 25
2
Part I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except per share amounts)
March 31, December 31,
2004 2003
-------------- --------------
(Unaudited)
Assets:
Investments:
Fixed maturities, at fair value (cost: 2004 - $1,266.5; 2003 - $1,154.9) $ 1,313.0 $ 1,190.9
Equity securities, at fair value (cost: 2004 - $109.6; 2003 - $107.0) 172.6 170.7
Other long-term investments, at fair value (cost: 2004 - $11.9; 2003 - $12.1) 12.9 12.5
Short-term investments, at fair value which approximates cost 150.2 179.1
-------------- --------------
Total investments 1,648.7 1,553.2
-------------- --------------
Cash and cash equivalents 33.8 75.6
Accrued investment income 12.8 14.6
Premiums receivable 236.1 246.1
Reinsurance recoverable 550.8 535.0
Notes receivable 37.9 46.4
Goodwill 105.7 105.7
Deferred federal income tax asset, net 27.1 27.5
Deferred acquisition costs, net 61.7 62.5
Other assets 109.7 99.9
-------------- --------------
Total assets $ 2,824.3 $ 2,766.5
============== ==============
Liabilities:
Reserves for losses and loss adjustment expenses $ 1,502.5 $ 1,480.8
Unearned premiums 349.4 353.3
Funds held 191.4 187.2
Deferred gain, retroactive reinsurance 42.9 43.3
Junior subordinated debentures 27.5 27.5
Income taxes payable, net 11.4 19.7
Accrued expenses and other liabilities 135.1 115.5
-------------- --------------
Total liabilities 2,260.2 2,227.3
-------------- --------------
Shareholders' equity:
Preferred stock -$0.10 par, 5,000,000 shares authorized
Series A mandatory convertible preferred stock - 2,953,310 shares
issued and outstanding at March 31, 2004 and December 31, 2003 0.3 0.3
Common stock - $0.10 par, 35,000,000 shares authorized; 27,596,825 and 27,596,325
shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively 2.8 2.8
Additional paid-in capital 223.6 220.5
Retained earnings 270.8 253.1
Deferred stock compensation (5.3) (2.6)
Accumulated other comprehensive income, net 71.9 65.1
-------------- --------------
Total shareholders' equity 564.1 539.2
-------------- --------------
Total liabilities and shareholders' equity $ 2,824.3 $ 2,766.5
============== ==============
See accompanying notes.
3
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except per share amounts)
(Unaudited)
Three Months Ended
March 31,
----------------------------
2004 2003
------------- -------------
Premiums and other revenue:
Earned premiums $ 153.8 $ 124.1
Net investment income 14.7 13.5
Realized investment gains, net 2.5 56.0
------------- -------------
Total revenue 171.0 193.6
------------- -------------
Expenses:
Losses and loss adjustment expenses 96.0 87.3
Underwriting, acquisition, and
insurance expenses 54.6 47.4
Interest expense 2.1 2.2
------------- -------------
Total expenses 152.7 136.9
------------- -------------
Income before income taxes 18.3 56.7
Provision for income taxes - 23.1
------------- -------------
Net income $ 18.3 $ 33.6
============= =============
Net income per common share:
Basic $ 0.64 $ 1.55
============= =============
Diluted $ 0.60 $ 1.55
============= =============
Weighted average common shares:
Basic 27,596,611 21,603,503
============= =============
Diluted 30,718,591 21,636,318
============= =============
See accompanying notes.
4
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
(Unaudited)
Three Months Ended
March 31,
-------------------------
2004 2003
------------ -----------
Net income $ 18.3 $ 33.6
------------ -----------
Other comprehensive income (loss):
Unrealized gains (losses)
on securities:
Gains (losses) arising during
the period 13.0 (9.0)
Reclassification adjustment
for (gains)/ losses included in net income (2.5) 1.6
------------ -----------
Other comprehensive income (loss) before tax 10.5 (7.4)
Income tax provision (benefit) related to other
comprehensive income (loss) 3.7 (2.6)
------------ -----------
Other comprehensive income (loss), net of tax 6.8 (4.8)
------------ -----------
Comprehensive income $ 25.1 $ 28.8
============ ===========
See accompanying notes
5
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(Unaudited)
Three Months Ended
March 31,
---------------------------
2004 2003
------------ ------------
Cash flows from operating activities:
Net income $ 18.3 $ 33.6
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization and depreciation 3.8 2.8
Deferred federal income tax expense (3.3) 9.6
(Gains) losses on sales of investments (2.5) 1.6
Gains on sales of real estate - (57.6)
Change in:
Accrued investment income 1.8 1.6
Receivables (5.8) 2.8
Unearned premiums on ceded reinsurance (8.5) (10.6)
Reserves for losses and loss adjustment expenses 21.7 30.6
Unearned premiums (3.9) 8.6
Other assets and liabilities, net (6.7) 4.1
------------ ------------
Cash provided by operating activities 14.9 27.1
------------ ------------
Cash flows from investing activities:
Sales of fixed maturity investments 105.9 4.2
Maturities and mandatory calls of fixed
maturity investments 70.5 75.2
Sales of equity securities 2.4 1.7
Purchases of fixed maturity investments (287.7) (148.7)
Purchases of equity securities (4.4) (0.7)
Change in short-term investments 28.9 (9.6)
Net cash received from sale of real estate 8.5 6.5
Other, net 20.0 7.7
------------ ------------
Cash used by investing activities (55.9) (63.7)
------------ ------------
Cash flows from financing activities:
Issuance of Series A mandatory convertible
preferred stock - 35.4
Related party note payable - 12.0
Secondary common stock offering expense (0.2) -
Payment of cash dividend on preferred stock (0.6) -
------------ ------------
Cash provided (used) by financing activities: (0.8) 47.4
------------ ------------
Change in cash and cash equivalents (41.8) 10.8
Cash and cash equivalents, beginning of period 75.6 77.4
------------ ------------
Cash and cash equivalents, end of period $ 33.8 $ 88.2
============ ============
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 its 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 for the year ended December 31, 2003 that the Company filed with the
Securities and Exchange Commission on March 15, 2004.
The interim financial data as of March 31, 2004 and 2003 and for the three
months ended March 31, 2004 and 2003 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 2004.
The balance sheet at December 31, 2003 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 December 2003, the FASB revised SFAS No. 132, "Employers' Disclosures about
Pensions and Other Postretirement Benefits". This Statement retains the
disclosures required by the original SFAS No. 132 and requires additional
disclosures regarding the assets, obligations, cash flows and net periodic
benefit cost of defined benefit pension and postretirement plans. In addition,
this Statement requires interim period disclosure of the components of net
period benefit cost and contributions if significantly different from previously
reported amounts. SFAS No. 132, as revised, is effective for fiscal years ending
after December 15, 2003. The Company adopted the provisions of SFAS No. 132, as
revised, effective December 15, 2003.
Effective November 2003, the Company curtailed its pension plan. This
curtailment resulted in a reduction of pension expense of $3.9 million, which
was recognized in 2003. As of the curtailment date, pension plan was over
funded, resulting in a prepaid pension asset of approximately $7.3 million. The
estimated pension liability as of the curtailment date was $25.2 million (vested
and non-vested participants). Based on the current funding status of the pension
plan, the effects of the curtailment, the expected changes in pension plan asset
values and pension obligations in 2004, the Company does not believe any
significant pension expense will be recognized during 2004. Additionally, the
Company believes that no significant funding of its pension plan will be
required during the year ended December 31, 2004.
7
Note 3 - Earnings Per Share
The following table presents the calculation of basic and diluted net income per
common share for the three months ended March 31, 2004 and 2003:
Three Months Ended
March 31,
--------------------------
(Dollars in millions except per share data) 2004 2003
------------ ------------
Net income $ 18.3 $ 33.6
Preferred stock dividends (0.6) -
------------ ------------
Income available to common shareholders 17.7 33.6
Effect of dilutive securities:
Preferred stock dividends 0.6 -
------------ ------------
Income available to common shareholders
after assumed conversion $ 18.3 $ 33.6
Weighted average shares-basic 27,596,611 21,603,503
Effect of dilutive securities:
Stock options 168,670 -
Convertible preferred stock 2,953,310 32,815
------------ ------------
Weighted average shares-diluted 30,718,591 21,636,318
============ ============
Net income per common share-basic $ 0.64 $ 1.55
Net income per common share-diluted $ 0.60 $ 1.55
For the three months ended March 31, 2004, options to purchase 1,180,800 shares
of common stock at a price ranging from $17.88 to $35.50 were not included in
the computation of diluted earnings per share as the options' exercise price was
greater than the average market price of the common shares. These options expire
at varying times from 2005 through 2014. For the three months ended March 31,
2003, options to purchase 1,829,550 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 as 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.
Note 4 - Dividends to Common Shareholders
In conjunction with the sale of the Series A Mandatory Convertible Preferred
Stock in March 2003, the Company suspended dividend payments to common
shareholders for a period of two years. No dividends were declared or paid to
common shareholders during the three months ended March 31, 2004 and 2003.
Note 5 - Income Taxes
The Company's income tax provision includes the following components:
Three Months Ended
March 31,
---------------------------
(in millions) 2004 2003
------------ ------------
Current tax provision $ 3.4 $ 6.3
Deferred tax provision (benefit) related to:
Future tax deductions 0.2 (3.5)
Net operating loss carryforward 2.7 21.3
Deferred alternative minimum tax provision (0.3) (1.2)
Valuation allowance change (6.0) 0.2
------------ ------------
Income tax provision $ - $ 23.1
============ ============
8
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
March 31,
---------------------------
(in millions) 2004 2003
------------ ------------
Income tax provision at statutory rates (35%) $ 6.4 $ 18.1
Tax effect of:
Tax exempt interest - (0.1)
Dividends received deduction (0.2) (0.2)
Valuation allowance change (6.0) 0.2
Other permanent adjustments, net (0.1) -
State income tax provision (0.1) 5.1
------------ ------------
Income tax provision $ - $ 23.1
============ ============
Deferred taxes arise from temporary differences in the recognition of revenues
and expenses for tax and financial reporting purposes. The Company's deferred
tax asset is supported by tax planning strategies, the reversal of taxable
temporary differences and the recognition of future income. For the three months
ended March 31, 2004, the Company reduced the deferred tax asset valuation
allowance by $6.0 million. At March 31, 2004, the Company has a deferred tax
asset of $27.1 million, net of a deferred tax asset valuation allowance of $43.1
million. The reduction of the deferred tax asset valuation allowance was based
on management's evaluation of the recoverability of the deferred tax asset.
Management regularly evaluates the recoverability of the deferred tax asset and
will adjust the valuation allowance accordingly.
Note 6 - 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 March 31, 2004, the Company had granted 272,137 shares of non-vested
stock. The non-vested shares vest in equal annual installments over a period of
three to four 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 March
31, 2004 and 2003, the Company recognized deferred stock compensation expense of
$0.3 million and $0.2 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. As of February 2, 2004, all of the performance
measures were met and the performance based options were issued. Due to timing
differences between the grant date and the measurement date of the options, the
Company is recognizing compensation expense over the vesting period of these
options. For the three months ended March 31, 2004, the Company recognized
compensation expense of $0.2 million related to these stock options.
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
March 31,
------------------
(in millions, except per share amounts) 2004 2003
--------- -------
Net income, as reported $ 18.3 $ 33.6
Add: Total deferred stock compensation expense included
in reported net income, net of taxes 0.3 0.1
Deduct: Total stock-based employee compensation
determined under fair value based methods for all
awards, net of tax (0.5) (0.2)
--------- -------
Pro forma net income $ 18.1 $ 33.5
========= =======
Earnings per share
Basic - as reported $ 0.64 $ 1.55
Basic - pro forma $ 0.63 $ 1.55
Diluted - as reported $ 0.60 $ 1.55
Diluted - pro forma $ 0.59 $ 1.55
Note 7 - 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 $30.0 million and
$26.2 million as of March 31, 2004 and 2003, respectively:
Three Months Ended
March 31,
-----------------------
(in millions) 2004 2003
----------- -----------
Net reserves - beginning of year $ 965.5 $ 838.2
Net reserves ceded under retroactive reinsurance contracts 0.4 (2.0)
Add:
Loss and LAE incurred during calendar year, net of reinsurance:
Current accident year 98.3 82.6
Prior accident years (2.3) 4.7
----------- -----------
Loss and LAE incurred during current accident year, net of reinsurance 96.0 87.3
Deduct:
Loss and LAE payments made during current calendar year, net of reinsurance:
Current accident year 5.0 5.5
Prior accident years 74.6 55.7
----------- -----------
Loss and LAE payments made during current calendar year, net of reinsurance: 79.6 61.2
----------- -----------
Net reserves, end of period 982.3 862.3
Add:
Reinsurance recoverable on unpaid losses & LAE, end of period 520.2 449.9
----------- -----------
Gross reserves - end of period $1,502.5 $1,312.2
=========== ===========
10
Note 8 - Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities are comprised of the following:
March 31, December 31,
(in millions) 2004 2003
------------ ------------
Accrued underwriting expenses $ 53.6 $ 58.9
Ceded reinsurance payable, net 34.5 28.8
Securities payable 25.3 5.2
Accrued policyholder dividends 3.5 3.9
Capital lease 4.3 4.2
Agency plant 4.2 4.2
Other liabilities 9.7 10.3
------------ ------------
Total accrued expenses and other liabilities $ 135.1 $ 115.5
============ ============
Note 9 - Underwriting, Acquisition and Insurance Expenses
Underwriting, acquisition and insurance expenses for the three months ended
March 31, 2004 and 2003 were as follows:
Three Months Ended
March 31,
-----------------------------
(in millions) 2004 2003
------------- -------------
Commissions $ 25.9 $ 21.9
General Expenses 22.5 23.0
State assessments 3.7 2.0
Taxes, licenses and bureau fees 2.4 2.9
------------- -------------
54.5 49.8
Deferral of policy acquisition costs 0.1 (2.4)
------------- -------------
Total underwriting, acquisition and
insurance expense $ 54.6 $ 47.4
============= =============
Note 10 - 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, risk management, specialty commercial 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.
11
Revenues and income before taxes for each reporting group were as follows:
Three Months Ended
March 31,
---------------------------
(in millions) 2004 2003
------------ ------------
Revenues:
Earned premiums
Excess & surplus lines $ 74.1 $ 62.0
Risk management 34.3 28.5
Specialty commercial 31.8 28.1
Public entity 13.6 5.5
Run-off lines - -
------------ ------------
Total earned premiums 153.8 124.1
Net investment income
Excess & surplus lines 4.7 3.4
Risk management 7.0 7.3
Specialty commercial 2.6 2.2
Public entity 0.3 0.2
Run-off lines - -
Corporate & other 0.1 0.4
------------ ------------
Total net investment income 14.7 13.5
Realized investment gains, net 2.5 56.0
------------ ------------
Total revenue $ 171.0 $ 193.6
============ ============
Income (loss) before income tax
Excess & surplus lines 11.9 7.9
Risk management 2.7 (8.0)
Specialty commercial 4.3 2.3
Public entity 0.9 0.3
Run-off lines - -
------------ ------------
Total segment income before taxes 19.8 2.5
Corporate & other (4.0) (1.8)
Net realized investment gains (losses) 2.5 (1.6)
Net realized gains on sales of real estate - 57.6
------------ ------------
Total income before income tax $ 18.3 $ 56.7
============ ============
Identifiable assets for each reporting group were as follows:
March 31, December 31,
(in millions) 2004 2003
--------------- ---------------
Excess & surplus lines $ 801.3 $ 744.2
Risk management 1,554.2 1,483.7
Specialty commercial 384.1 370.2
Public entity 80.9 80.9
Run-off lines - -
Corporate & other 3.8 87.5
--------------- ---------------
Total $ 2,824.3 $ 2,766.5
=============== ===============
Note 11 - Supplemental Cash Flows Information
Income taxes paid. The Company paid income taxes of $11.6 million during the
three months ended March 31, 2004. No income taxes were paid for the same period
ended 2003.
Interest paid. The Company paid interest on the junior subordinated debentures
of $0.2 million during the three months ended March 31, 2004. No interest was
paid by the Company during the three months ended March 31, 2003.
12
Notes receivable. The Company received non-cash proceeds in the form of notes
receivable in the amount of $51.2 million in conjunction with the sales of
certain real estate holdings during the three months ended March 31, 2003. Cash
payments in the amount of $8.5 million were received during the three months
ended March 31, 2004, and the balance of these notes was $37.9 million as of
March 31, 2004.
Note 12 - 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 three months ended March 31, 2004, these payments totaled $0.1 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 March 31, 2004, Fayez Sarofim & Co. managed $151.7
million fair value 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.
On March 31, 2003, Colony Insurance Company entered into a quota share
reinsurance agreement with HCC Insurance Holdings, Inc. ("HCC"), a greater than
10% shareholder. For the three months ended March 31, 2004, the Company ceded
approximately $14.4 million of gross written premiums, $12.7 million of earned
premiums and $7.3 million of losses and loss adjustment expenses. The Company
earned a ceding commission of $2.5 million.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share
reinsurance agreement with HCC. Under the original terms of the agreement, the
Company assumed 3.33% of the premiums and losses under HCC's USA Directors and
Officers Liability program, and 5.0% of the premiums and losses under HCC's
International Directors and Officers Liability program. Effective January 1,
2004, the agreement was amended and Argonaut Insurance Company now assumes 1.5%
of the premiums and losses under each program. For the three months ended March
31, 2004, gross written premiums recorded under this program totaled $1.7
million. For the three months ended March 31, 2004, the Company expensed ceding
and other commissions of $0.6 million related to this business.
Note 13 - Subsequent Events
On April 14, 2004, the Bankruptcy Court presiding over the Chapter 11 Bankruptcy
of MacArthur Company, Western MacArthur Company, and Western Asbestos Company
(the "MacArthur Companies") entered orders giving final approval to settlements
reached with all property and casualty insurers of the MacArthur Companies
currently in litigation, including Argonaut Insurance Company. A bankruptcy
reorganization plan filed by the MacArthur Companies will be implemented and all
existing and future claims against the MacArthur Companies related to asbestos
will be channeled solely to a trust. Argonaut Insurance Company contributed
$29.8 million into the bankruptcy trust and received a release from the
MacArthur Companies as to any and all existing or future asbestos-related
claims, including any claims for extra-contractual relief, arising directly or
indirectly out of any alleged coverage under the nine Argonaut Insurance Company
polices at issue. In addition, claimants seeking funds from the trust will be
required to execute release and indemnity agreements in favor of Argonaut
Insurance Company as a condition to receiving payment. In its 2003 Form 10-K,
the Company estimated that approximately 1% of the existing liabilities
associated with previous suits and the entry of default judgments being sought
in the litigation were associated with operations covered by the Argonaut
Insurance Company. Argonaut Insurance Company's portion of the funds contributed
by all carriers to the bankruptcy trust as final settlement of both existing and
future liabilities in this matter represents approximately 0.5% of the total
funding.
13
On April 29, 2004, Argonaut Group Statutory Trust IV, a wholly-owned subsidiary
of the Company, sold 13,000 Floating Rate Capital Securities (liquidation amount
$1,000 per Capital Security) in a private sale for $13.0 million. The Trust used
the proceeds from this sale to buy a series of Floating Rate Junior Subordinated
Deferrable Interest Debentures due 2034 from the Company.
The interest rate on the Debentures and the Capital Securities is equal to
3-Month LIBOR plus 3.85% (not to exceed 12.5% on or after May 15, 2009), which
rate will be reset quarterly. The Debentures are unsecured and subordinated in
right of payment to all of the Company's future senior indebtedness. After April
29, 2009, the Company will have the right to redeem the Debentures, in whole or
in part, at a price equal to 100% of the principal amount of the Debentures,
plus accrued and unpaid interest to the date of redemption. The Company will
also have the right to redeem all of the Debentures prior to April 29, 2009 upon
the happening of specified events at a price ranging from 105% to 101% of the
principal amount of the Debentures, plus accrued and unpaid interest to the date
of redemption.
The Company will use the net proceeds from the sale of the Debentures for
general corporate purposes.
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 months ended
March 31, 2004 and 2003. 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 for the year
ended December 31, 2003 that the Company filed with the Securities and Exchange
Commission on March 15, 2004.
Forward Looking Statements
Management's Discussion and Analysis of Results of Operations and Financial
Conditions, Qualitative and Quantitative Disclosures 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.
Results of operations
The following is a comparison of selected data from the Company's operations:
Three Months Ended
March 31,
----------------------------
(in millions) 2004 2003
------------- -------------
Gross written premiums $ 200.1 $ 173.9
============= =============
Earned premiums $ 153.8 $ 124.1
Net investment income 14.7 13.5
Realized investment gains, net 2.5 56.0
------------- -------------
Total revenue $ 171.0 $ 193.6
============= =============
Income before taxes 18.3 56.7
Provision for income taxes - 23.1
------------- -------------
Net income $ 18.3 $ 33.6
============= =============
Combined ratio 97.9% 108.5%
============= =============
The increase in consolidated gross written premiums was primarily attributable
to an increase in renewal business. For the three months ended March 31, 2004,
consolidated gross written premiums from renewal business totaled $102.1
million, compared to $81.9 million for the same period in 2003. The increase in
premiums on renewal business was primarily the result of rate increases across
virtually all lines of business. Also included in consolidated gross written
premiums for the three months ended March 31, 2004 was $91.9 million in premiums
15
from new business, compared to $100.8 million for the same period of 2003. The
Company entered into two renewal rights agreements in December 2003, which
accounted for approximately $8.0 million of premiums from new business in the
first three months of 2004. Consolidated gross written premiums for the three
months ended March 31, 2004 were also impacted by approximately $12.0 million of
premiums written and assumed under various reinsurance agreements, partially
offset by endorsements and cancellations of $5.9 million. The increase in
consolidated earned premiums for the three months ended March 31, 2004 as
compared to the same period in 2003 was primarily the result of growth in all
lines due to rate increases and new business written in 2003 as well as business
emanating from renewal rights acquisitions entered into in 2002 and 2003.
Consolidated net investment income was comparable between periods due to lower
yields offset by higher invested balances due to the investment of proceeds from
various capital raising initiatives combined with positive cash flows from
operations. Consolidated invested assets totaled $1,648.7 million and $1,249.9
million at March 31, 2004 and 2003, respectively.
The Company manages its investment portfolio to minimize losses, both realized
and unrealized. Realized investment gains for the three months ended March 31,
2004 were $2.5 million, compared to $56.0 million for the same period in 2003.
Realized investment gains for the three months ended March 31, 2003 included
gains on sales of three real estate holdings totaling $57.6 million. Included in
realized investment gains as of March 31, 2003 are write downs of $2.3 million
due to the recognition of other than temporary impairments of securities. As of
March 31, 2004, no other than temporary impairments were identified in the
Company's investment portfolio.
Consolidated losses and loss adjustment expenses were $96.0 million and $87.3
million for the three months ended March 31, 2004 and 2003, respectively. The
consolidated loss ratios were 62.4% for the three months ended March 31, 2004,
compared to 70.3% for the three months ended March 31, 2003. The improvement in
the loss ratios was primarily attributable to the effects of rate increases
implemented over the past two years coupled with the restructuring of the risk
management segment (see discussion below). Losses and loss adjustment expenses
for the three months ended March 31, 2003 include reserve strengthening of
approximately $5.0 million within the risk management segment for prior accident
years (see discussion below).
Consolidated underwriting, acquisition and insurance expenses were $54.6 million
and $47.4 million for the three months ended March 31, 2004 and 2003,
respectively. The consolidated expense ratios were 35.5% and 38.2% for the three
months ended September March 31, 2004 and 2003, respectively. The improvement in
the expense ratios was primarily due to increased premium volumes.
Consolidated interest expense was $2.1 million and $2.2 million for the three
months ended March 31, 2004 and 2003, respectively. Interest expense of
approximately $1.6 million and $2.1 million for the three months ended March 31,
2004 and 2003, respectively, was recorded by the Company for funds withheld by
the Company under a retroactive reinsurance contract. Additionally, during 2004,
the Company recorded approximately $0.4 million of interest expense related to
the junior subordinated debentures issued by the Company during 2003.
The consolidated provision for income taxes for the three months ended March 31,
2004 was $0, due to a reduction of the deferred tax asset valuation allowance of
$6.0 million. The reduction of the deferred tax asset valuation allowance was
based on management's evaluation of the recoverability of the deferred tax
asset. Management anticipates that the deferred tax asset valuation allowance
will ultimately be recovered in the future. Management regularly evaluates the
recoverability of the deferred tax asset and will adjust the valuation allowance
accordingly. The consolidated provision for income taxes for the three months
ended March 31, 2003 was $23.1 million, primarily due to the recognition of
federal and state taxes on the gains from the sale of real estate during the
period.
16
Segment Results
As of March 31, 2004, the Company's operations include four on-going business
segments: excess and surplus lines, risk management, specialty commercial and
public entity. Additionally, the Company has one run-off segment for products it
no longer underwrites. 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.
Excess and Surplus Lines. The following table summarizes the excess and surplus
lines results of operations for the three months ended March 31, 2004 and 2003:
Three Months Ended
March 31,
----------------------------
(in millions) 2004 2003
------------- -------------
Gross written premiums $ 99.8 $ 84.6
============= =============
Earned premiums 74.1 62.0
Losses and loss adjustment expenses 44.6 38.5
Underwriting expense 22.3 19.0
------------- -------------
Underwriting income 7.2 4.5
Investment income, net 4.7 3.4
------------- -------------
Income before taxes $ 11.9 $ 7.9
============= =============
Combined ratio 90.3% 92.6%
============= =============
The increase in gross written premiums for the three months ended March 31, 2004
was primarily attributable to rate increases on renewal business. For the three
months ended March 31, 2004, gross written premiums derived from renewal
business increased $21.1 million to $45.9 million from $24.8 million for the
same period in 2003. Gross written premiums related to new business declined to
$59.8 million for the three months ended March 31, 2004, compared to $66.1
million for the same period of 2003 The decline was primarily attributable to
increased competition in the excess and surplus market, as well as from the
standard market, primarily in property lines of business. Partially offsetting
these increases were cancellations and endorsements, which reduced gross written
premiums by approximately $5.9 million and $6.3 million for the three months
ended March 31, 2004 and 2003, respectively.
Earned premiums increased $12.1 million to $74.1 million for the three months
ended March 31, 2004, compared to $62.0 million for the same period in 2003. The
increase in earned premiums was primarily due to premium growth in 2003.
Partially offsetting the increase in earned premiums are premiums ceded under a
quota share reinsurance agreement of approximately $12.6 million. In the first
quarter of 2003, this agreement was not in effect.
The excess and surplus lines segment's loss ratios were 60.2% and 62.0% for the
three months ended March 31, 2004 and 2003, respectively. The improvement was
primarily the result of rate increases realized over the past year. Loss
reserves for the excess and surplus lines were $369.3 million as of March 31,
2004, compared to $203.5 million as of March 31, 2003.
The expense ratio for the three months ended March 31, 2004 was 30.1% compared
to 30.6% for the same period in 2003. Gains from economies of scale resulting
from the increase in gross written premiums related to fixed expenses were
partially offset by increases in variable expenses.
17
The increase in net investment income was the result of an increase in invested
assets due to positive cash flow over the past twelve months, combined with a
capital contribution of $12.5 million. Net invested assets increased to $520.9
million as of March 31, 2004, compared to $393.6 million as of March 31, 2003.
Risk Management. The following table summarizes the results of operations for
the risk management segment for the three months ended March 31, 2004 and 2003:
Three Months Ended
March 31,
----------------------------
(in millions) 2004 2003
------------- ------------
Gross written premiums $ 43.1 $ 43.6
============= ============
Earned premiums 34.3 28.5
Losses and loss adjustment expenses 22.5 26.5
Underwriting expense 14.5 17.3
------------- ------------
Underwriting loss (2.7) (15.3)
Investment income, net 7.0 7.3
------------- ------------
Income (loss) before taxes $ 4.3 $ (8.0)
============= ============
Combined ratio 107.8% 153.6%
============= ============
Gross written premiums for the three months ended March 31, 2004 were $0.5
million lower than the same period in 2003. This change in gross written
premiums is not reflective of the shift in written premiums toward casualty risk
management solutions for upper-middle market accounts announced in March 2003.
Gross written premiums for the upper middle market accounts increased $11.3
million to $31.1 million, of which $13.2 million was new business and $17.9
million was renewal business.
The remaining gross written premiums in the first quarter of 2004 were made up
of $4.8 million for certain agreements for which the Company cedes a majority of
the premiums and receives a ceding commission, and $1.7 million was for premiums
assumed under a quota share agreement from insurance subsidiaries of HCC
Insurance Holdings, Inc. ("HCC") for directors and officers coverage. The gross
written premiums for these two programs for the first quarter of 2003 were $7.0
million and $0, respectively, as the HCC agreement was executed in the second
quarter of 2003. During the first quarter of 2004, $3.6 million of premiums was
assumed from involuntary pools as compared to $1.0 million for the same period
in 2003. The exit from non-strategic products resulted in gross written premiums
of $1.8 million in the first quarter of 2004 as this business runs off, compared
to $16.0 million for the same period in 2003.
Earned premiums for the three months ended March 31, 2004 were $5.8 million
higher than the same period in 2003. This increase was primarily driven by $5.0
million of additional earned premiums on upper middle market accounts. Increases
in earned premiums in the first quarter of 2004 compared to the same period in
2003 amounted to $3.1 million for premiums earned under the HCC agreement, and
$2.6 million for premiums assumed from involuntary pools. These increases were
largely offset by decreased earned premiums for non-strategic products for which
the Company is exiting.
Loss and loss adjustment expenses for the three months ended March 31, 2004
resulted in a loss ratio of 65.3%, compared to 92.7% for the same period in
2003. The improved loss experience in the first quarter of 2004 as compared to
the first quarter of 2003 was primarily attributable to $5.0 million of adverse
development recorded in the first quarter of 2003. The adverse development was
attributable to one multi-year construction account that was non-renewed in
January 2003. Additionally, beginning in 2003, the Company has focused on
writing accounts targeting casualty risk management solutions for upper-middle
market insureds which have produced a better loss ratio than the non-strategic
products that the Company has exited. Loss reserves were $645.0 million and
$633.7 million as of March 31, 2004 and 2003, respectively.
18
The expense ratio for the three months ended March 31, 2004 was 42.5%, compared
to 60.9% for the same period in 2003. Restructuring efforts initiated in the
first three months of 2003 resulted in $1.0 million of restructuring costs
recorded in that quarter for personnel costs and other associated costs. This
effort along with continued expense management initiatives have resulted in
decreased levels of expenses in the first quarter of 2004. The Company has also
benefited from economies of scale as earned premiums have increased while
absolute levels of expenses have declined.
Investment income decreased in the three months ended March 31, 2004 as compared
to 2003 due to lower yields, partially offset by higher invested balances.
Invested assets were $792.9 million as of March 31, 2004, compared to $614.3
million as of March 31, 2003.
Specialty Commercial. The following table summarizes the specialty commercial
results of operations the three months ended March 31, 2004 and 2003:
Three Months Ended
March 31,
-----------------------------
(in millions) 2004 2003
-------------- -------------
Gross written premiums $ 41.1 $ 34.4
============== =============
Earned premiums 31.8 28.1
Losses and loss adjustment expenses 20.9 19.5
Underwriting expense 10.8 8.5
-------------- -------------
Underwriting income 0.1 0.1
Investment income, net 2.6 2.2
-------------- -------------
Income before taxes $ 2.7 $ 2.3
============== =============
Combined ratio 99.6% 99.5%
============== =============
The increase in gross written premiums was primarily attributable to new
business written under a renewal rights agreement entered into in the fourth
quarter of 2003. Gross written premium from new business was $13.3 million for
the three months ended March 31, 2004, compared to $8.1 million for the same
period ended 2003. The renewal rights agreement resulted in approximately $5.7
million of additional gross written premiums in 2004. Renewal premiums increased
from $26.3 million for the three months ended March 31, 2003 to $27.8 million
for the same period in 2004. The increases in renewal premiums were primarily
due to rate increases. The increase in earned premiums in 2004 as compared to
2003 was primarily a result of the increase in gross written premiums in 2003.
The specialty commercial segment's loss ratios were 65.9% and 69.4% for the
three months ended March 31, 2004 and 2003, respectively. The improvement in the
loss ratio was primarily the result of rate increases over the past year. This
segment did not experience any significant catastrophe losses during the three
months ended March 31, 2004. The specialty commercial segment's loss reserves
were $192.6 million and $177.1 million as of March 31, 2004 and 2003,
respectively.
The expense ratios for the specialty commercial segment were 33.8% and 30.1% for
the three months ended March 31, 2004 and 2003, respectively. The increase in
the expense ratio was primarily attributable to start-up costs of approximately
$0.9 million relating to the renewal rights acquisition previously discussed.
The increase in investment income for the three months ended March 31, 2004, as
compared to the same period in 2003, was primarily the result of an increase in
invested assets due to positive cash flows partially offset by lower investment
yields. Invested assets were $263.7 million as of March 31, 2004, compared to
$226.3 million as of March 31, 2003.
19
Public Entity. The following table summarizes the results of operations for the
public entity segment for the three months ended March 31, 2004 and 2003:
Three Months Ended
March 31,
-----------------------------
(in millions) 2004 2003
------------- -------------
Gross written premiums $ 16.1 $ 11.3
============= =============
Earned premiums 13.6 5.5
Losses and loss adjustment expenses 8.5 3.6
Underwriting expense 4.5 1.8
------------- -------------
Underwriting income 0.6 0.1
Investment income, net 0.3 0.2
------------- -------------
Income before taxes $ 0.9 $ 0.3
============= =============
Combined ratio 96.0% 98.8%
============= =============
The increase in gross written premiums for the three months ended March 31, 2004
as compared to 2003 was primarily the result of renewal business written in
2004. For the three months ended March 31, 2004, the public entity segment wrote
$10.5 million of renewal business, compared to $4.1 million in 2003.
Additionally, during the three months ended March 31, 2004, the segment wrote
new business of approximately $5.6 million, of which $2.3 million is
attributable to a renewal rights agreement entered into in the fourth quarter of
2003. For the three months ended March 31, 2003, the segment wrote approximately
$7.2 million of premium from new business. The increase in earned premiums for
the three months ended March 31, 2004, as compared to the same period in 2003
was primarily attributable to premium growth during 2003.
Losses and loss adjustment expenses for the three months ended March 31, 2004
resulted in a loss ratio of 62.8% compared to 65.4% for the same period in 2003.
The decrease in the loss ratio was primarily attributable to rate increases.
Loss reserves for the public entity segment were $34.9 million and $8.8 million
as of March 31, 2004 and 2003, respectively.
The expense ratio for the three months ended March 31, 2004 was 33.2%, compared
to 33.4% for the same period in 2003. The expense ratios continue to be
favorably impacted by operational efficiencies and economies of scale from
increased premium volume.
The increase in investment income for the three months ended March 31, 2004, as
compared to the same period in 2003, was primarily the result of an increase in
invested assets due to positive cash flows partially offset by lower investment
yields. Invested assets were $41.8 million as of March 31, 2004, compared to
$15.7 million as of March 31, 2003.
Run-off Lines. The Company has discontinued 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 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:
20
March 31,
--------------------------------------------
2004 2003
--------------------- ---------------------
(in millions) Gross Net Gross Net
---------- ---------- ---------- ----------
Environmental and asbestos:
Loss reserves, beginning of the period $219.5 $180.0 $236.5 $178.3
Incurred losses - - - -
Losses paid 5.8 3.0 3.0 3.4
---------- ---------- ---------- ----------
Loss reserves - environmental and
asbestos, end of the period 213.7 177.0 233.5 174.9
Other run-off lines 47.0 37.2 55.7 43.5
Net reserves ceded - retroactive
reinsurance contract - (42.4) - (40.0)
---------- ---------- ---------- ----------
Total reserves - run-off lines $260.7 $171.8 $289.2 $178.4
========== ========== ========== ==========
The Company regularly monitors the activity of claims within the run-off lines,
particularly those claims related to asbestos and environmental liabilities.
Management believes the reserves for losses and loss adjustment expenses are
adequate based on current facts and circumstances.
On April 14, 2004, the Bankruptcy Court presiding over the Chapter 11 Bankruptcy
of MacArthur Company, Western MacArthur Company, and Western Asbestos Company
(the "MacArthur Companies") entered orders giving final approval to settlements
reached with all property and casualty insurers of the MacArthur Companies
currently in litigation, including Argonaut Insurance Company. A bankruptcy
reorganization plan filed by the MacArthur Companies will be implemented and all
existing and future claims against the MacArthur Companies related to asbestos
will be channeled solely to a trust. Argonaut Insurance Company contributed
$29.8 million into the bankruptcy trust and received a release from the
MacArthur Companies as to any and all existing or future asbestos-related
claims, including any claims for extra-contractual relief, arising directly or
indirectly out of any alleged coverage under the nine Argonaut Insurance Company
polices at issue. In addition, claimants seeking funds from the trust will be
required to execute release and indemnity agreements in favor of Argonaut
Insurance Company as a condition to receiving payment. In its 2003 Form 10-K,
the Company estimated that approximately 1% of the existing liabilities
associated with previous suits and the entry of default judgments being sought
in the litigation were associated with operations covered by the Argonaut
Insurance Company. Argonaut Insurance Company's portion of the funds contributed
by all carriers to the bankruptcy trust as final settlement of both existing and
future liabilities in this matter represents approximately 0.5% of the total
funding. Based on information currently available to the Company, management's
best estimate of Argonaut Insurance Company's asbestos and environmental
reserves remains unchanged following the settlement.
Reinsurance
Certain of the Company's reinsurance carriers have experienced deteriorating
financial condition and/or have been downgraded by rating agencies. Amounts due
from such reinsurers on paid loss recoverables and case reserves totaled $25.3
million as of March 31, 2004. Amounts due from such reinsurers on incurred but
not reported claims totaled $30.0 million as of March 31, 2004. 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 the insurance subsidiaries, not
Trenwick Group Ltd.
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. At present, the Company
carries a reserve of $23.9 million as an estimate of the amount of uncollectable
reinsurance. Management will continue to monitor the collectibility of
21
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.
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 three months ended March 31, 2004, these payments totaled $0.1 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 March 31, 2004, Fayez Sarofim & Co. managed $151.7
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.
On March 31, 2003, Colony Insurance Company entered into a quota share
reinsurance agreement with HCC, a greater than 10% shareholder. For the three
months ended March 31, 2004, the Company ceded approximately $14.4 million of
gross written premiums, $12.7 million of earned premiums and $7.3 million of
losses and loss adjustment expenses. The Company earned a ceding commission of
$2.5 million.
Effective January 1, 2003, Argonaut Insurance Company entered into a quota share
reinsurance agreement with HCC. Under the original terms of the agreement, the
Company assumed 3.33% of the premiums and losses under HCC's USA Directors and
Officers Liability program, and 5.0% of the premiums and losses under HCC's
International Directors and Officers Liability program. Effective January 1,
2004, the agreement was amended and Argonaut Insurance Company now assumes 1.5%
of the premiums and losses under each program. For the three months ending March
31, 2004, gross written premiums recorded under this program totaled $1.7
million. For the three months ended March 31, 2004, the Company expensed ceding
and other commissions of $0.6 million related to this business.
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 three months ended March 31, 2004, consolidated net cash provided by
operating activities was $14.9 million, compared to $27.1 million for the same
period in 2003. The decrease in cash flows from operating activities for the
three months ended March 2004 as compared to 2003 was primarily attributable to
a decrease in net income partially offset by timing differences due to growth in
all lines of business.
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 for the year ended December 31, 2003 that the Company filed with the
Securities and Exchange Commission on March 15, 2004 for further discussion on
the Company's liquidity.
Recent Accounting Pronouncements and Critical 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.
22
Critical Accounting Policies
Refer to "Critical Accounting Policies" in the Company's Annual Report on Form
10-K for the year ended December 31, 2003 that the Company filed with the
Securities and Exchange Commission on March 15, 2004 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. Qualitative and Quantitative Disclosures About Market Risk
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 and investments in foreign securities. Accounts
under the International Directors and 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 or losses related to the exchange rates. For the three months
ended March 31, 2004, the Company received payments of $0.8 million on this
contract. Gains on the foreign currency translation were insignificant.
Management is unable at this time to estimate future foreign currency gains or
losses, if any. Changes in the value of foreign investments related to
fluctuations in foreign currency exchange rates are included in unrealized gains
or losses. The amount of unrealized gains as of March 31, 2004 and 2003 were
$0.8 million and $0.1 million, respectively.
The Company holds a 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. The marketable
equity securities are carried on the balance sheet at fair market value, and are
subject to the risk of potential loss in market value resulting from adverse
changes in prices. Equity price risk is managed primarily by monitoring funds
committed to the various types of securities owned and by limiting the exposure
in any one investment or type of investment. No issuer (exclusive of the U.S.
government and U.S. governmental agencies) of fixed income or equity securities
represents more than 10% of shareholders' equity as of March 31, 2004.
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 risks 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 for municipal bonds, corporate
bonds and preferred stocks). Less than 1.0% of the fixed income portfolio is
invested in bonds rated lower than "BBB".
The Company regularly evaluates its investment portfolio for indication of other
than temporary impairments to the individual securities. For the three months
ended March 31, 2004, no securities were identified as having an other than
temporary impairment. During the three months ended March 31, 2003, the Company
recognized other than temporary losses on the investment portfolio of $2.3
million.
Management has assessed these risks and believes that there have been no
material changes since December 31, 2003.
23
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 March 31, 2004.
There have been no changes in the Company's internal controls over financial
reporting during the three months ended March 31, 2004 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.
24
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
Lila Mitchell, et al. v. Argonaut Insurance Company, et al. On April 14, 2004,
the Bankruptcy Court presiding over the Chapter 11 Bankruptcy of MacArthur
Company, Western MacArthur Company, and Western Asbestos Company (the "MacArthur
Companies") entered orders giving final approval to settlements reached with all
property and casualty insurers of the MacArthur Companies currently in
litigation, including Argonaut Insurance Company. A bankruptcy reorganization
plan filed by the MacArthur Companies will be implemented and all existing and
future claims against the MacArthur Companies related to asbestos will be
channeled solely to a trust. Argonaut Insurance Company contributed $29.8
million into the bankruptcy trust and received a release from the MacArthur
Companies as to any and all existing or future asbestos-related claims,
including any claims for extra-contractual relief, arising directly or
indirectly out of any alleged coverage under the nine Argonaut Insurance Company
polices at issue. In addition, claimants seeking funds from the trust will be
required to execute release and indemnity agreements in favor of Argonaut
Insurance Company as a condition to receiving payment. In its 2003 Form 10-K,
the Company estimated that approximately 1% of the existing liabilities
associated with previous suits and the entry of default judgments being sought
in the litigation were associated with operations covered by the Argonaut
Insurance Company. Argonaut Insurance Company's portion of the funds contributed
by all carriers to the bankruptcy trust as final settlement of both existing and
future liabilities in this matter represents approximately 0.5% of the total
funding.
Refer to Part I, Item 3 - "Legal Proceedings" in the Company's Annual Report on
Form 10-K for the year ended December 31, 2003 that the Company filed with the
Securities and Exchange Commission on March 15, 2004 for additional discussion
on the Company's pending legal proceedings.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
None
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.
25
(b) Reports on Form 8-K
On February 4, 2004, the Company furnished a current report on Form 8-K
under Item 12 of Form 8-K announcing its operating results for the
quarter and year ended December 31, 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
May 7, 2004
27
EXHIBIT INDEX
Exhibit
No. Description
12.1 Statement of Computation of Ratio of Earnings to Fixed Charges and
Preferred Stock Dividends
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.
32.1 Certificate of the Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
32.2 Certificate of the Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
28
EXHIBIT 12.1
ARGONAUT GROUP, INC.
STATEMENT OF COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES
AND PREFERRED STOCK DIVIDENDS
Three months ended
March 31, Years Ended December 31,
--------------------- ---------------------------------------------------------
2004 2003 2003 2002 2001 2000 1999
--------- --------- ---------- --------- --------- ---------- ---------
(in millions, except ratios)
Earnings:
Income from continuing operations
before provision for income taxes $ 18.3 $ 56.7 $ 135.3 $(21.1) $ 3.3 $ (129.2) $(25.5)
Add:
Fixed charges 3.2 2.7 12.3 2.6 2.9 2.3 1.5
--------- --------- ---------- --------- --------- ---------- ---------
Total earnings $ 21.5 $ 59.4 $ 147.6 $(18.5) $ 6.2 $ (126.9) $(24.0)
========= ========= ========== ========= ========= ========== =========
Fixed charges
Interest expense, net $ 2.1 $ 2.2 $ 8.4 $ 0.4 $ 0.2 $ - $ -
Preferred stock dividends 0.6 - 1.8 - - - -
Rental interest factor 0.5 0.5 2.1 2.2 2.7 2.3 1.5
--------- --------- ---------- --------- --------- ---------- ---------
Total fixed charges $ 3.2 $ 2.7 $ 12.3 $ 2.6 $ 2.9 $ 2.3 $ 1.5
========= ========= ========== ========= ========= ========== =========
Ratio of earnings to fixed charges 6.7:1 22.0:1 12.0:0 (A) 2.1:1 (B) (C)
========= ========= ========== ========= ========= ========== =========
(A) Earnings were inadequate to cover fixed costs by $21.1 million
(B) Earnings were inadequate to cover fixed costs by $129.2 million
(C) Earnings were inadequate to cover fixed costs by $25.5 million
29
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 a 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 7th day of May, 2004.
/s/ Mark E. Watson III
------------------------
Mark E. Watson III
President and Chief
Executive Officer
30
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 a 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 7th day of May, 2004.
/s/ Mark W. Haushill
--------------------------
Mark W. Haushill
Vice President
Chief Financial Officer
and Treasurer
31
EXHIBIT 32.1
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 months ended March 31, 2004 ("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 7th day of May, 2004.
/s/ Mark E. Watson III
--------------------------
Mark E. Watson III
President and Chief
Executive Officer
32
EXBIBIT 32.2
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 months ended March 31, 2004 ("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 7th day of May, 2004.
/s/ Mark W. Haushill
--------------------------
Mark W. Haushill
Vice President
Chief Financial Officer
and Treasurer
33