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, 2005
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 10, 2005
Title Outstanding
Common Stock, par value $0.10 per share 27,887,457
ARGONAUT GROUP, INC.
TABLE OF CONTENTS
Page No.
Part I. FINANCIAL INFORMATION:
Item 1. Consolidated Financial Statements (unaudited):
Consolidated Balance Sheets
March 31, 2005 and December 31, 2004................................ 3
Consolidated Statements of Income
Three months ended March 31, 2005 and 2004.......................... 4
Consolidated Statements of Comprehensive Income
Three months ended March 31, 2005 and 2004.......................... 5
Consolidated Statements of Cash Flows
Three months ended March 31, 2005 and 2004.......................... 6
Notes to the Consolidated Financial Statements......................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations.................. 16
Item 3. Qualitative and Quantitative Disclosures About Market Risk....... 24
Item 4. Controls and Procedures......................................... 25
Part II. OTHER INFORMATION:
Item 1. Legal Proceedings................................................ 26
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds...... 26
Item 3. Defaults Upon Senior Securities.................................. 26
Item 4. Submission of Matters to a Vote of Security Holders.............. 26
Item 5. Other Information................................................ 26
Item 6. Exhibits......................................................... 26
2
Part I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except except number of shares and per share amounts)
March 31, December 31,
2005 2004
-------------- --------------
(Unaudited)
Assets:
Investments:
Fixed maturities, at fair value (cost: 2005 - $1,513.8; 2004 - $1,454.3) $ 1,504.8 $ 1,470.7
Equity securities, at fair value (cost: 2005 - $117.5; 2004 - $115.3) 180.8 180.8
Other long-term investments, at fair value (cost: 2005 - $17.3; 2004 - $17.5) 20.0 20.0
Short-term investments, at fair value which approximates cost 124.1 112.4
-------------- --------------
Total investments 1,829.7 1,783.9
-------------- --------------
Cash and cash equivalents 17.6 31.7
Accrued investment income 16.9 16.9
Premiums receivable 240.2 249.9
Reinsurance recoverables 615.4 597.4
Notes receivable 37.2 37.8
Goodwill 106.3 106.3
Current income taxes receivable, net - 3.6
Deferred federal income tax asset, net 61.1 45.6
Deferred acquisition costs, net 67.5 70.0
Other assets 135.3 130.1
-------------- --------------
Total assets $ 3,127.2 $ 3,073.2
============== ==============
Liabilities:
Reserves for losses and loss adjustment expenses $ 1,647.4 $ 1,607.5
Unearned premiums 376.1 390.8
Funds held 200.3 197.4
Ceded reinsurance payable, net 26.9 32.2
Deferred gain, retroactive reinsurance 46.3 45.1
Junior subordinated debentures 113.4 113.4
Current income taxes payable, net 7.8 -
Accrued expenses and other liabilities 94.5 83.4
-------------- --------------
Total liabilities 2,512.7 2,469.8
-------------- --------------
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, 2005 and December 31, 2004 0.3 0.3
Common stock - $0.10 par, 70,000,000 shares authorized; 27,868,721 and 27,704,341
shares issued and outstanding at March 31, 2005 and December 31, 2004, respectively 2.8 2.8
Additional paid-in capital 235.0 230.3
Retained earnings 347.7 322.4
Deferred stock compensation (7.9) (6.9)
Accumulated other comprehensive income, net 36.6 54.5
-------------- --------------
Total shareholders' equity 614.5 603.4
-------------- --------------
Total liabilities and shareholders' equity $ 3,127.2 $ 3,073.2
============== ==============
See accompanying notes.
3
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in millions, except per share amounts)
(Unaudited)
Three Months Ended
March 31,
-----------------------
2005 2004
---------- ----------
Premiums and other revenue:
Earned premiums $ 162.1 $ 153.8
Net investment income 19.8 14.7
Realized investment gains, net 1.9 2.5
---------- ----------
Total revenue 183.8 171.0
---------- ----------
Expenses:
Losses and loss adjustment expenses 97.1 96.0
Underwriting, acquisition and insurance expense 57.9 54.6
Interest expense 3.8 2.1
---------- ----------
Total expenses 158.8 152.7
---------- ----------
Income before income taxes 25.0 18.3
Income tax benefit (1.0) -
---------- ----------
Net income $ 26.0 $ 18.3
========== ==========
Net income per common share:
Basic $ 0.91 $ 0.64
========== ==========
Diluted $ 0.83 $ 0.60
========== ==========
Weighted average common shares:
Basic 27,773,506 27,596,611
========== ==========
Diluted 31,143,175 30,718,591
========== ==========
See accompanying notes.
4
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
(Unaudited)
Three Months Ended
March 31,
------------------------
2005 2004
----------- -----------
Net income $ 26.0 $ 18.3
----------- -----------
Other comprehensive income (loss):
Unrealized gains (losses) on securities:
Gains (losses) arising during the period (25.6) 13.0
Reclassification adjustment for gains
included in net income (1.9) (2.5)
----------- ----------
Other comprehensive income (loss) before tax (27.5) 10.5
Income tax provision (benefit) related to other
comprehensive income (loss) (9.6) 3.7
----------- ----------
Other comprehensive income (loss), net of tax (17.9) 6.8
----------- ----------
Comprehensive income $ 8.1 $ 25.1
=========== ==========
See accompanying notes
5
ARGONAUT GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
Three Months Ended
March 31,
--------------------------
2005 2004
----------- ------------
Cash flows from operating activities:
Net income $ 26.0 $ 18.3
Adjustments to reconcile net income to
net cash provided by operations:
Amortization and depreciation 5.0 3.8
Deferred federal income tax benefit (5.8) (3.4)
Gains on sales of investments (1.9) (2.5)
Change in:
Accrued investment income - 1.8
Premiums and reinsurance receivables (8.3) (5.8)
Unearned premiums on ceded reinsurance 1.6 (8.5)
Reserves for losses and loss adjustment expenses 39.9 21.7
Unearned premiums (14.7) (3.9)
Income taxes 11.4 (8.3)
Deferred policy acquisition costs 2.5 0.8
Accrued underwriting expenses and funds held (12.9) (1.1)
Deferred gain, retroactive reinsurance 1.2 (0.4)
Other assets and liabilities, net 9.6 2.4
----------- ------------
Cash provided by operating activities 53.6 14.9
----------- ------------
Cash flows from investing activities:
Sales of fixed maturity investments 31.1 105.9
Maturities and mandatory calls of fixed maturity investments 33.1 70.5
Sales of equity securities 16.1 2.4
Purchases of fixed maturity investments (126.0) (287.7)
Purchases of equity securities (16.3) (4.4)
Change in short-term investments (11.7) 28.9
Principal payments received on real estate notes 0.6 8.5
Other, net 4.3 20.0
----------- ------------
Cash used in investing activities (68.8) (55.9)
----------- ------------
Cash flows from financing activities:
Stock options exercised and employee stock purchase plan issuance 1.7 -
Secondary common stock offering - (0.2)
Payment of cash dividend to preferred shareholders (0.6) (0.6)
----------- ------------
Cash provided by (used in) financing activities: 1.1 (0.8)
----------- ------------
Change in cash and cash equivalents (14.1) (41.8)
Cash and cash equivalents, beginning of period 31.7 75.6
----------- ------------
Cash and cash equivalents, end of period $ 17.6 $ 33.8
=========== ============
See accompanying notes
6
ARGONAUT GROUP, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
Note 1 - Basis of Presentation
The accompanying 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 normally is 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, 2004 that the Company filed with the
Securities and Exchange Commission on March 14, 2005.
The interim financial data as of March 31, 2005 and 2004 and for the three
months ended March 31, 2005 and 2004 is unaudited. However, in the opinion of
management, the interim data includes 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 2005.
The balance sheet at December 31, 2004 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 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 123 - Revised "Share-Based Payment",
replacing SFAS No. 123 and superseding Accounting Principles Board Opinion No.
25. SFAS No. 123-R requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the financial statements
based on their fair values beginning with the first interim or annual period
after June 15, 2005. The pro forma disclosures previously allowed under SFAS No.
123 no longer will be an alternative to financial statement recognition. SFAS
No. 123-R allows companies to select between the binomial method and the
Black-Scholes method for the calculation of fair value. The transition methods
for adoption include the modified-prospective and modified-retroactive methods.
Under the modified-retroactive method, prior periods may be restated either as
of the beginning of the year of adoption or for all periods presented. The
modified-prospective method requires that compensation expense be recorded for
all unvested stock options and restricted stock that exist upon the adoption of
Statement 123-R.
On April 14, 2005, the Securities and Exchange Commission announced the adoption
of a new rule that amends the compliance dates for SFAS 123-R. Under the new
rule, companies will be allowed to implement SFAS 123-R at the beginning of
their next fiscal year, instead of the first reporting period that begins after
June 15, 2005. The Company anticipates implementing SFAS 123-R effective January
1, 2006. The Company currently is evaluating the requirements of Statement
123-R. As of March 31, 2005, the Company has approximately $7.5 million of
unamortized fair value relating to stock options, net of tax, to be amortized
over 4 years.
Note 3 - 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, 2005 and 2004.
7
The declaration and payment of future dividends to holders of the Company's
common stock will be at the discretion of the Company's Board of Directors and
will depend upon many factors, including the Company's financial condition,
earnings, capital requirements of the Company's operating subsidiaries, legal
requirements, regulatory constraints and other factors as the Board of Directors
deems relevant. Dividends would be paid by the Company only if declared by its
Board of Directors out of funds legally available, subject to any other
restrictions that may be applicable to the Company.
Note 4 - 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, 2005 and 2004:
Three Months Ended
March 31,
--------------------------------
(in millions except number of shares and per share data) 2005 2004
--------------- ---------------
Net income $ 26.0 $ 18.3
Preferred stock dividends (0.6) (0.6)
--------------- ---------------
Income available to common shareholders 25.4 17.7
Effect of dilutive securities:
Preferred stock dividends 0.6 0.6
--------------- ---------------
Income available to common shareholders
after assumed conversion $ 26.0 $ 18.3
Weighted average shares-basic 27,773,506 27,596,611
Effect of dilutive securities:
Stock options 416,359 168,670
Convertible preferred stock 2,953,310 2,953,310
--------------- ---------------
Weighted average shares-diluted 31,143,175 30,718,591
=============== ===============
Net income per common share-basic $ 0.91 $ 0.64
Net income per common share-diluted $ 0.83 $ 0.60
For the three months ended March 31, 2005, options to purchase 447,303 shares of
common stock at prices ranging from $21.32 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 2013. For the three months ended March 31,
2004, options to purchase 1,180,800 shares of common stock at prices 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 2013.
Note 5 - Commitments and Contingencies
On August 30, 1996, the Los Angeles County Metropolitan Transportation Authority
("MTA") filed a civil action against Argonaut Insurance Company alleging breach
of contract, breach of the covenant of good faith and fair dealing, and
requesting ancillary relief in the form of an accounting, an injunction and
restitution in connection with allegations regarding failures to perform under
certain contracts of insurance. The MTA contends that it has been damaged by an
unspecified amount.
Argonaut Insurance Company has responded to the complaint, and believes it has
meritorious defenses, and intends to vigorously contest these claims.
Additionally, Argonaut Insurance Company brought certain counterclaims against
the MTA in connection with the facts underlying the lawsuit regarding the
coverage provided under the insurance policy issued, particularly reimbursement
of claims paid on behalf of the MTA by Argonaut Insurance Company. Reimbursement
is being sought on claims because the amounts paid were within the MTA's
8
deductible limits or above the MTA's policy limits and therefore due either from
the MTA or excess reinsurers under the terms of the policy issued. In the ten
years prior to the dispute, the MTA reimbursed Argonaut Insurance Company for
all such amounts on a regular basis in the ordinary course of business. The
Company is owed approximately $47.6 million relating to amounts funded below the
deductible limit or in excess of policy limits and accordingly due under the
terms of the insurance policy and such amount is included in premiums
receivable. Management has consulted with its attorneys regarding the merits of
the Company's claim and based on these discussions believe the $47.6 million
owed to Argonaut Insurance Company to be a valid claim. Further, management
believes the MTA has the financial wherewithal to pay the Company's claim. In
addition to the above amounts, Argonaut Insurance Company is seeking collection
of certain unpaid administrative claim handling fees and prejudgment interest on
all amounts due which are not included in the aforementioned receivable.
In the fourth quarter of 2004, shortly before the first phase of trial was to
begin, the trial judge for the MTA litigation considered several additional
motions for summary adjudication relating to the remaining MTA affirmative
defenses and Argonaut's right to prove and recover certain categories of
damages. All motions were ruled upon in Argonaut's favor. As a result of those
rulings, trial was postponed to allow the MTA to file an interlocutory appeal of
those and other rulings. The MTA filed its appellate pleadings as to each issue
on January 27, 2005. The appeals were denied summarily by the Court of Appeals
on January 31, 2005. The trial date for the first phase of the case has yet to
be reset.
During 2004 the Company and its insurance subsidiaries received a number of
formal and informal inquiries, subpoenas and/or requests for information from
state and federal agencies in connection with certain ongoing, industry-wide
investigations of contingent compensation arrangements, fictitious quotes, bid
rigging, tying arrangements and finite insurance products. In each instance, the
Company has cooperated with the agency making the request and provided a timely
response. The Company believes that its business activities and related
accounting and disclosure practices comply fully with all applicable regulatory
and legal requirements. The Company has received no indication that any agency
intends to initiate regulatory or legal action adverse to the Company based on
the Company's responses.
The insurance subsidiaries of the Company are parties to legal actions
incidental to their business. Based on the advice of counsel, management of the
Company believes that the resolution of these matters will not materially affect
the Company's financial condition or results of operations.
Note 6 - Income Taxes
The Company's income tax provision includes the following components:
Three Months Ended
March 31,
-------------------------
(in millions) 2005 2004
----------- ------------
Current tax provision $ 4.8 $ 3.4
Deferred tax provision (benefit) related to:
Future tax deductions (0.7) 0.2
Net operating loss carryforward - 2.7
Deferred alternative minimum tax provision 3.8 (0.3)
Valuation allowance change (8.9) (6.0)
----------- -----------
Income tax benefit $ (1.0) $ -
=========== ===========
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
March 31,
-------------------------
(in millions) 2005 2004
----------- ------------
Income tax provision at statutory rates $ 8.7 $ 6.4
Tax effect of:
Dividends received deduction (0.2) (0.2)
Valuation allowance change (8.9) (6.0)
Other permanent adjustments, net 0.1 (0.1)
State income tax provision (0.7) (0.1)
----------- -----------
Income tax benefit at statutory rates $ (1.0) $ -
=========== ===========
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, 2005, the Company reduced the deferred tax asset valuation
allowance by $8.9 million. At March 31, 2005, the Company has a deferred tax
asset of $61.1 million, net of a deferred tax asset valuation allowance of $16.1
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 7 - Share-based Payments
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.
In May 2004, the shareholders approved an amendment to the Company's Amended and
Restated Stock Incentive Plan (the "Amended Plan"). The Amended Plan provides
for the following: (a) prohibits any reduction in the exercise price of an
option without shareholder approval; (b) increases the number of shares
available under the plan by 1,750,000; (c) limits grants to individual employees
to 300,000 shares within any calendar year (except in the year of their initial
employment); (d) prohibits the granting of options with an exercise price below
fair market value on the date of grant; (e) reduces the maximum duration of
future grants to seven years; and (f) extends the expiration date of the Plan to
April 2, 2014. Under the Amended Plan, an aggregate of 6,250,000 shares of the
Company's common stock may be issued to certain executives and other key
employees, of which approximately 2,300,000 are available for distribution. The
stock awards may be in the form of incentive stock options, non-qualified stock
options, non-vested stock awards and stock appreciation rights.
Under the Amended Plan, up to 1,250,000 shares may be issued as non-vested stock
to officers and certain key employees. The 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 and
participants in the plan are not entitled to any voting or dividend rights until
after the stock has been issued. As of March 31, 2005, 289,379 shares are
outstanding under the plan, net of forfeitures of 36,597 shares. Of the shares
outstanding, 64,326 shares will vest subject to the achievement of an objective
performance goal. Upon granting of the non-vested stock, unearned compensation
equivalent to the market value at the date of grant is charged to shareholders'
equity and subsequently amortized to expense ratably over the vesting period.
For the three months ended March 31, 2005 and 2004, the Company recognized
compensation expense of $0.7 million and $0.3 million, respectively.
10
In August 2003, the Company authorized stock option awards to certain executives
and other key employees whose vesting was contingent upon the employee meeting
defined performance measures. Upon meeting the performance measures, the options
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 for the difference between the
exercise price of the option and the fair market value of the Company's common
stock as of the measurement date over the vesting period of these options. For
the three months ended March 31, 2005 and 2004, the Company recognized
compensation expense related to these stock options of $0.1 million and $0.2
million, respectively.
In August 2004, the Company authorized stock option awards to certain executives
and other key employees whose vesting was contingent upon the employee meeting
defined performance measures. Upon meeting the performance measures, the options
will vest over a four-year term. As of January 14, 2005, the majority of the
performance measures were met and these options were issued. Due to timing
differences between the grant date and the measurement date of the options, the
Company is recognizing compensation expense for the difference between the
exercise price of the option and the fair market value of the Company's common
stock as of the measurement date over the vesting period of these options. For
the three months ended March 31, 2005, the Company recognized compensation
expense related to these stock options of $0.2 million.
In August 2004, the Compensation Committee of the Board of Directors approved a
restorative options feature to all options granted prior to February 2, 2004
which had exercise prices greater than or equal to $16.21 per share. This
modification to the existing options grants resulted in compensation expense of
approximately $0.4 million for the three months ended March 31, 2005.
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) 2005 2004
------------- ------------
Net income, as reported $ 26.0 $ 18.3
Add: Total deferred stock compensation expense
included in reported net income, net of taxes 0.9 0.3
Deduct: Total stock-based employee compensation
determined under fair value based methods for
all awards, net of tax (1.1) (0.5)
------------- ------------
Pro forma net income $ 25.8 $ 18.1
============= ============
Earnings per share
Basic - as reported $ 0.91 $ 0.64
Basic - pro forma $ 0.90 $ 0.63
Diluted - as reported $ 0.83 $ 0.60
Diluted - pro forma $ 0.83 $ 0.59
Note 8 - 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 $57.1 million and
$30.0 million as of March 31, 2005 and 2004, respectively:
11
Three Months Ended
March 31,
-----------------------
(in millions) 2005 2004
----------- -----------
Net reserves - beginning of year $ 1,060.8 $ 965.5
Change in net reserves ceded under retroactive reinsurance contracts (1.3) 0.4
Add:
Loss and LAE incurred during calendar year, net of reinsurance:
Current accident year 102.5 98.3
Prior accident years (5.4) (2.3)
----------- -----------
Loss and LAE incurred during current calendar year, net of reinsurance 97.1 96.0
Deduct:
Loss and LAE payments made during current calendar year, net of reinsurance:
Current accident year 5.4 5.0
Prior accident years 62.0 74.6
----------- -----------
Loss and LAE payments made during current calendar year, net of reinsurance: 67.4 79.6
----------- -----------
Net reserves, end of period 1,089.2 982.3
Add:
Reinsurance recoverable on unpaid losses & LAE, end of period 558.2 520.2
----------- -----------
Gross reserves - end of period $ 1,647.4 $ 1,502.5
=========== ===========
Favorable loss development on prior accident years recognized during 2005 was
primarily the result of a $4.0 million reduction for involuntary pool prior
accident year ultimate losses for the risk management segment.
In the opinion of management, the Company's reserves represent the best estimate
of its ultimate liabilities, based on currently known facts, current law,
current technology, and assumptions considered reasonable where facts are not
known. Due to the significant uncertainties mentioned above and related
management judgments, there can be no assurance that future loss development,
favorable or unfavorable, will not occur.
Note 9 - Business Segments
The Company primarily is 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, select markets (formerly know as
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.
12
Revenues and income before taxes for each segment were as follows:
Three Months Ended
March 31,
----------------------------
(in millions) 2005 2004
------------- -------------
Revenues:
Earned premiums
Excess & surplus lines $ 78.2 $ 74.1
Risk management 21.1 34.3
Select markets 46.2 31.8
Public entity 16.6 13.6
Run-off lines - -
------------- -------------
Total earned premiums 162.1 153.8
Net investment income
Excess & surplus lines 6.5 4.7
Risk management 8.1 7.0
Select markets 3.4 2.6
Public entity 1.1 0.3
Run-off lines - -
Corporate & other 0.7 0.1
------------- -------------
Total net investment income 19.8 14.7
Realized investment gains, net 1.9 2.5
------------- -------------
Total revenue $ 183.8 $ 171.0
============= =============
Income (loss) before income tax
Excess & surplus lines 13.3 11.9
Risk management 7.6 2.7
Select markets 5.1 4.3
Public entity 1.9 0.9
Run-off lines - -
------------- -------------
Total segment income before taxes 27.9 19.8
Corporate & other (4.8) (4.0)
Net realized investment gains 1.9 2.5
------------- -------------
Total income before income tax $ 25.0 $ 18.3
============= =============
Identifiable assets for each segment were as follows:
March 31, December 31,
(in millions) 2005 2004
--------------- ----------------
Excess & surplus lines $ 1,016.1 $ 972.4
Risk management 1,435.9 1,475.7
Select markets 492.6 428.8
Public entity 146.0 148.5
Run-off lines - -
Corporate & other 36.6 47.8
--------------- ----------------
Total $ 3,127.2 $ 3,073.2
=============== ================
Note 10 -Underwriting, Acquisition and Insurance Expenses
Underwriting, acquisition and insurance expenses for the three months ended
March 31, 2005 and 2004 were as follows:
13
Three Months Ended
March 31,
--------------------
(in millions) 2005 2004
--------- ---------
Commissions $ 23.6 $ 25.9
General Expenses 26.9 22.5
State assessments 2.1 3.7
Taxes, licenses and bureau fees 2.8 2.4
--------- ---------
55.4 54.5
Deferral of policy acquisition costs 2.5 0.1
--------- ---------
Total underwriting, acquisition and insurance expense $ 57.9 $ 54.6
========= =========
Note 11 - Related Party Transactions
Fayez Sarofim. 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, 2005, 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, 2005, Fayez Sarofim & Co. managed
a portion of the Company's investments with a fair value of $162.4 million. 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.
David Hartoch. Swett & Crawford, a member of the Aon family of companies, is the
largest wholesale insurance broker in the country, placing nearly $3 billion in
premium volume in their most recent fiscal year. David Hartoch, who is a member
of the Company's Board of Directors, was the Chairman and Chief Executive
Officer of Swett & Crawford from 1997 to 2003 and was reappointed as President
and Chief Executive Officer on March 31, 2005. For the three months ended March
31, 2005, the Company, through its Colony Group, placed insurance through Swett
& Crawford totaling $3.8 million in gross written premiums. Swett & Crawford
earned $0.6 million in commissions on this business.
Allan W. Fulkerson. In August, 2002, the Company committed to a $5.0 million
investment, as a limited partner, in Century Capital Partners III, L.P.
("CCPIII"), an investment partnership which specializes in investing in the
insurance industry. In April 2003, CCPIII purchased 500,000 shares of the
Company's Series A Mandatory Convertible Preferred Stock. In addition, the
Company has been informed that in 2004 CCM, LLC (a related party of CCP III)
distributed or sold 100,000 shares of the Company's common stock that it had
previously acquired in a separate partnership with similar objectives of
investing in the insurance industry.
The Company and Asset Allocation Management Company, LLC ("AAM") are parties to
an agreement dated March 1, 2004, pursuant to which AAM manages a portion of the
Company's fixed income securities in accordance with the Company's investment
policy. Century Capital Management, LLC ("CCML"), a successor to Century Capital
Management, Inc., manages two partnerships (Century Capital Partners II, L.P.
and CCPIII) that collectively have a majority ownership interest in AAM. As of
March 31, 2005, AAM managed $724.5 million of fixed income securities. The
Company paid AAM $0.2 million for these services for the three months ended
March 31, 2005.
Allan W. Fulkerson, who is a member of the Company's Board of Directors, serves
as a consultant to CCML. Prior to December 31, 2004, Mr. Fulkerson also served
as a director of the general partner of CCPIII. Mr. Fulkerson retains a 7%
ownership interest in the general partner of CCPIII. As such, he has an indirect
ownership interest in AAM of less than one-half of one percent.
14
Note 12 - Supplemental Cash Flows Information
Income taxes. The Company paid income taxes of $1.0 million and received a tax
refund in the amount of $9.1 million during the three months ended March 31,
2005. Income taxes of $11.6 million were paid during the three months ended
March 31, 2004.
Interest paid. The Company paid interest on the junior subordinated debentures
of $1.8 million and $0.2 million during the three months ended March 31, 2005,
and 2004, respectively.
Note 13 - Subsequent Events
On April 1, 2005, the Company announced it had entered into an agreement with
Fireman's Fund Insurance Company to acquire the renewal rights and certain
operating assets of the Binding Authority business segment, currently
underwritten by Interstate Insurance Group, a subsidiary of Fireman's Fund
Insurance Company. The Company will begin offering policies that meet the
Company's underwriting standards to the Binding Authority customers in the
second quarter of 2005 through its excess and surplus lines segment.
15
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following is a discussion and analysis of the consolidated results of
financial condition and operations of Argonaut Group, Inc. and its subsidiaries
(collectively, "Argonaut Group" or the "Company") for the three months ended
March 31, 2005 and 2004. It should be read in conjunction with the consolidated
financial statements and other data presented herein as well as with
Management's Discussion and Analysis of Financial Condition and Results of
Operation contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 2004 that the Company filed with the Securities and Exchange
Commission on March 14, 2005.
Forward Looking Statements
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Qualitative and Quantitative Disclosures About Market Risk and the
accompanying Consolidated Financial Statements (including the notes thereto) may
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, government investigations into industry practices, developments
relating to existing agreements, heightened competition, changes in pricing
environments and changes in asset valuations. For a more detailed discussion of
risks and uncertainties, see the Company's public filings made with the
Securities and Exchange Commission. The Company undertakes no obligation to
publicly update any forward-looking statements.
Results of operations
The following is a comparison of selected data from the Company's operations:
Three Months Ended
March 31,
------------------------
(in millions) 2005 2004
----------- ----------
Gross written premiums $ 206.7 $ 200.1
=========== ==========
Earned premiums $ 162.1 $ 153.8
Net investment income 19.8 14.7
Realized investment gains, net 1.9 2.5
----------- ----------
Total revenue $ 183.8 $ 171.0
=========== ==========
Income (loss) before taxes 25.0 18.3
Provision (benefit) for income taxes (1.0) -
----------- ----------
Net income $ 26.0 $ 18.3
=========== ==========
Combined ratio 95.6% 97.9%
=========== ==========
The increase in consolidated gross written premiums for the three months ended
March 31, 2005 as compared to 2004 was primarily attributable to an increase in
premiums from renewal business. Premiums from renewal business were $127.9
million for the three months ended March 31, 2005, compared to $102.1 million
for the same period of 2004. The increase in premiums from renewal business was
primarily the result of an increase in the amount of business inforce subject to
renewal. Consolidated gross written premiums from new business declined to $70.5
million for the three months ended March 31, 2005 as compared to $91.9 million
for the same period in 2004. The decline in premiums from new business was the
16
result of a renewal rights acquisition completed in the fourth quarter of 2003
which resulted in new business in the first quarter of 2004, coupled with
increased competition across all segments of the Company. Renewal rights
acquisitions completed in the fourth quarter of 2003 accounted for $8.0 million
in new business in the first quarter of 2004. Consolidated gross written
premiums for the three months ended March 31, 2005 and 2004 included $10.8
million and $12.0 million, respectively, for premiums written and assumed under
various reinsurance agreements, partially offset by cancellations and
endorsements of $2.5 million and $5.9 million, respectively.
Consolidated net investment income increased approximately 35% to $19.8 million
for the three months ended March 31, 2005 compared to the same period in 2004
due to higher invested balances resulting from the investment of proceeds from
various capital raising initiatives during 2004 combined with positive cash
flows from operations. Consolidated invested assets totaled $1,829.7 million and
$1,648.7 million at March 31, 2005 and 2004, respectively.
The Company manages its investment portfolio to minimize losses, both realized
and unrealized. Realized investment gains for the three months ended March 31,
2005 were $1.9 million, compared to $2.5 million for the same period in 2004.
The Company regularly evaluates its investment portfolio for indications of
other than temporary impairments to its holdings. If individual securities are
determined to have an other than temporary impairment, the security is written
down to the fair market value. During the three months ended March 31, 2005 and
2004, the Company did not incur any other than temporary impairment losses in
its investment portfolio.
The Company's net unrealized gains on investment securities declined by $17.9
million, net of tax, during the three months ended March 31, 2005 to $36.6
million. The decrease was primarily attributable to rising interest rates, which
negatively impacted the fair market value of the Company's fixed income
portfolio. The Company has the ability and intent to hold the portion of the
fixed income portfolio that is in an unrealized loss position to their maturity.
Consolidated losses and loss adjustment expenses were $97.1 million and $96.0
million for the three months ended March 31, 2005 and 2004, respectively. The
consolidated loss ratio for the three months ended March 31, 2005 was 59.9%,
compared to 62.4% for the same period in 2004. The improvement in the loss ratio
for the three months ended March 31, 2005 was primarily attributable to
improvement in the risk management segment (see discussion below). Consolidated
loss reserves were $1,647.4 million and $1,502.5 million as of March 31, 2005
and 2004, respectively.
Consolidated underwriting, acquisition and insurance expenses increased to $57.9
million for the three months ended March 31, 2005 as compared to $54.6 million
for the same period in 2004. The increase was primarily the result of increased
premium volumes. The consolidated expense ratios were comparable at 35.7% and
35.5% for the three months ended March 31, 2005 and 2004, respectively.
Consolidated interest expense was $3.8 million and $2.1 million for the three
months ended March 31, 2005 and 2004, respectively. Interest expense includes
$1.8 million and $1.6 million for the three months ended March 31, 2005 and
2004, respectively, for funds withheld by the Company under a retroactive
reinsurance contract. Interest expense resulting from the junior subordinated
debentures was $1.8 million for the three months ended March 31, 2005, compared
to $0.4 million for the three months ended March 31, 2004. The increase in this
interest expense is the result of the issuance of an additional $85.9 million in
trust preferred debentures during 2004.
The consolidated income tax benefit for the three months ended March 31,
2005 was $1.0 million, and includes a reduction of the deferred tax valuation
allowance of $8.9 million. During 2005, the Company reduced its liability for
accrued taxes by $1.0 million due to the settlement of a state tax issue. The
consolidated provision for income taxes for the three months ended March 31,
2004 was $0, including a reduction in the deferred tax asset valuation allowance
of $6.0 million. The reduction of the deferred tax valuation allowance in 2005
and 2004 was based on management's consideration of limited amounts of future
income in accordance with Statement of Financial Accounting Standard ("SFAS")
No. 109, "Accounting for Income Taxes," combined with earnings reported in these
periods. Management anticipates the valuation allowance will ultimately be
recovered in the future. The Company evaluates the adequacy of the valuation
allowance on a regular basis.
17
Segment results
As of March 31, 2005, the Company's operations include four on-going business
segments: excess and surplus lines, risk management, select markets 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 consideration
of realized gains or losses from the sales of investments. Management excludes
realized gains for the evaluation of segment results, as decisions regarding the
sales of investments are made at the corporate level. Although this measure of
profit (loss) does not replace net income (loss) computed in accordance with
accounting principles generally accepted in the United States as a measure of
profitability, management utilizes this measure of profit (loss) to focus its
segments on generating operating income which excludes realized gains and losses
on sales of investments.
On April 21, 2005, the Company announced that it had changed the name of its
specialty commercial segment to select markets. The Company believes that the
new name more accurately reflects the risk selection and operations of this
growing segment.
Excess and surplus lines. The following table summarizes the results of
operations for the excess and surplus lines segment for the three months ended
March 31, 2005 and 2004:
Three Months Ended
March 31,
-----------------------------
(in millions) 2005 2004
------------- --------------
Gross written premiums $ 100.8 $ 99.8
============= ==============
Earned premiums 78.2 74.1
Losses and loss adjustment expenses 47.0 44.6
Underwriting expense 24.4 22.3
------------- --------------
Underwriting income 6.8 7.2
Investment income, net 6.5 4.7
------------- --------------
Income before taxes $ 13.3 $ 11.9
============= ==============
Combined ratio 91.4% 90.3%
============= ==============
Gross written premiums from renewal business totaled $55.5 million for the three
months ended March 31, 2005 as compared to $45.9 million for the same period in
2004. A larger base of expiring premiums was the primary driver for the increase
in renewal premiums in 2005. Gross written premiums from new business declined
to $47.8 million for the three months ended March 31, 2005, compared to $59.8
million for the same period in 2004. The decline in gross written premiums from
new business was primarily attributable to increased competition in the excess
and surplus market, as well as from the standard market. Gross written premiums
were offset by cancellations and endorsements of approximately $2.5 million and
$5.9 million for the three months ended March 31, 2005 and 2004, respectively.
The increase in earned premium was primarily attributable to premium growth in
2004.
The excess and surplus lines segment's loss ratios for the three month periods
ended March 31, 2005 and 2004 were 60.2%. The Company has not experienced any
adverse loss development associated with the hurricane activity during the third
quarter of 2004. Loss reserves for the excess and surplus lines were $503.4
million and $369.3 million as of March 31, 2005 and 2004, respectively.
18
The expense ratio for the three months ended March 31, 2005 was 31.2%, compared
to 30.1% for the same period in 2004. The increase was primarily attributable to
start up costs associated with the formation of another division within excess
and surplus lines, Argonaut Specialty. Argonaut Specialty plans on underwriting
excess and surplus risks that are somewhat larger than the Company has written
in the past. Argonaut Specialty will lever the existing infrastructure within
the Company's excess and surplus lines segment and plans to write property,
primary casualty and excess casualty risks. During the first quarter of 2005,
expenses incurred associated with Argonaut Specialty increased the expense ratio
as the Company had not yet underwritten any policies. Management anticipates
this division will generate earned premiums beginning in the second quarter of
2005, but is unable to estimate the level of earned premiums at this time.
The increase in net investment income was the result of higher invested assets
due to positive cash flows, combined with capital contributions over the past
year. Net invested assets were $677.9 million as of March 31, 2005, compared to
$520.9 million at March 31, 2004.
On April 1, 2005, the Company announced it had entered into an agreement with
Fireman's Fund Insurance Company to acquire the renewal rights and certain
operating assets of the Binding Authority business segment, currently
underwritten by Interstate Insurance Group, a subsidiary of Fireman's Fund
Insurance Company. The Company will begin offering policies that meet the
Company's underwriting standards to the Binding Authority customers in the
second quarter of 2005 through its excess and surplus lines segment.
Risk management. The following table summarizes the results of operations for
the risk management segment for the three months ended March 31, 2005 and 2004:
Three Months Ended
March 31,
----------------------------
(in millions) 2005 2004
------------- -------------
Gross written premiums $ 34.8 $ 43.1
============= =============
Earned premiums 21.1 34.3
Losses and loss adjustment expenses 10.9 22.5
Underwriting expense 10.7 14.5
------------- -------------
Underwriting loss (0.5) (2.7)
Investment income, net 8.1 7.0
------------- -------------
Income before taxes $ 7.6 $ 4.3
============= =============
Combined ratio 102.5% 107.8%
============= =============
The risk management segment was restructured in the first quarter of 2003,
focusing on casualty risk management solutions written on a loss sensitive
basis. Gross written premiums from renewal loss sensitive polices were $19.6
million for the three months ended March 31, 2005, compared to $17.9 million for
the same period in 2004. Gross written premiums for new loss sensitive policies
were $4.5 million for the three months ended March 31, 2005, compared to $13.2
million for the same period in 2004.
The Company's loss sensitive business consists of a mix of large deductible and
retrospectively rated policies. During the first quarter of 2005, gross written
premiums were below management's expectations due to competition in the
marketplace for these type policies. Also contributing to lower gross written
premiums was a mix shift to large deductible policies which produce lower gross
written premiums when a policy is issued than do retrospectively rated policies.
Insureds selecting large deductible polices pay a lower premium in exchange for
retaining the risk of loss for their large deductible loss exposure.
Included in gross written premiums for the three months ended March 31, 2005
were $8.8 million primarily related to premiums written for insurance programs
marketed by certain state funds in jurisdictions where the state funds are not
licensed. Gross written premiums under these agreements were $4.8 million for
the same period in 2004. Premiums assumed under quota share agreements with
19
insurance subsidiaries of HCC Insurance Holdings, Inc. ("HCC") for directors and
officers coverage were $1.9 million and $1.7 million for the three months ended
March 31, 2005 and 2004, respectively. Premiums assumed from involuntary pools
were $0.1 million for the three months ended March 31, 2005 compared to $3.6
million for the same period in 2004, with the decrease primarily caused by the
pools reallocating prior year results to reflect the Company's actual market
shares in the respective state pools. Included in gross written premiums for the
three months ended March 31, 2004 were $1.8 million for non-strategic products
that the Company began exiting in 2003. The Company had no written premiums
related to these products in the three months ended March 31, 2005.
Earned premiums for the Company's risk management loss sensitive business were
$19.2 million and $24.5 million for the three months ended March 31, 2005 and
2004, respectively. Consistent with the discussion for gross written premiums, a
mix shift toward large deductible policies as well as competition for loss
sensitive business has resulted in lower earned premiums. Earned premiums for
the HCC directors' and officers' coverage were $1.7 million and $3.1 million for
the three months ended March 31, 2005 and 2004, respectively. The Company
reduced its quota share assumed percentage for this business effective January
1, 2004, and the earning of premium assumed during 2003 in the first quarter of
2004 is resulting in the higher earned premiums for the first quarter of 2004.
Earned premiums for involuntary pools decreased to $0.2 million in the first
quarter of 2005 as compared to $3.6 million for the same quarter in 2004 due to
the reallocation of prior year results discussed above. Finally, non-strategic
products which the Company has exited produced returned premiums of $0.1 million
in the first quarter of 2005 compared to $3.2 million of earned premiums for the
same period in 2004.
Losses and loss adjustment expenses resulted in a loss ratio of 51.8% for the
three months ended March 31, 2005, compared to 65.3% for the same period in
2004. The loss ratio for the Company's risk management loss sensitive business
was approximately 52.4% percent for the three months ended March 31, 2005
compared to 60.7% for the same three months in 2004. The improved loss ratio is
being driven by the mix shift toward large deductible accounts which produce a
lower loss ratio than retrospectively rated accounts. The primary causes for the
remainder of the variation in loss ratios for the first quarter of 2005 compared
to 2004 is due to the effects of the involuntary pools, including $4.0 million
of favorable development on prior accident years, and the effect of the exit
from non-strategic products on the weighted average loss ratio for the
respective quarters. Loss reserves were $637.0 million and $645.0 million as of
March 31, 2005 and 2004, respectively.
The expense ratio for the three months ended March 31, 2005 was 50.7%, compared
to 42.5% for the same period in 2004. The increase in the expense ratio was
primarily a result of lower premium earned due to competition for loss sensitive
policies as well as the mix shift toward large deductible policies which incur
approximately the same amount of underwriting costs as do retrospectively rated
policies. Because large deductible policies produce lower premium volume as a
result of the insured retaining the large deductible risk, the expense ratio has
been driven higher as the mix of business has shifted more to large deductible
policies from retrospectively rated policies.
Net investment income increased to $8.1 million for the three months ended March
31, 2005, as compared to $7.0 million for the same period of 2004. Included in
net investment income for the three months ended March 31, 2005 was $0.8 million
in interest income received from a Federal income tax refund. During 2004, the
Company restructured its fixed income investment portfolio, investing in higher
yielding securities which contributed to the increase in net investment income
for the three months ended March 31, 2005.
Select markets. The following table summarizes the select markets results of
operations the three months ended March 31, 2005 and 2004:
20
Three Months Ended
March 31,
----------------------------
(in millions) 2005 2004
------------- -------------
Gross written premiums $ 52.9 $ 41.1
============= =============
Earned premiums 46.2 31.8
Losses and loss adjustment expenses 29.4 20.9
Underwriting expense 15.1 10.8
------------- -------------
Underwriting income 1.7 0.1
Investment income, net 3.4 2.6
------------- -------------
Income before taxes $ 5.1 $ 2.7
============= =============
Combined ratio 96.5% 99.6%
============= =============
The increase in gross written premiums was primarily attributable to a renewal
rights acquisition executed in the fourth quarter of 2003 that was not effective
until February 1, 2004. The renewal rights acquisition contributed gross written
premiums of $13.5 and $5.7 million for the three months ended March 31, 2005 and
2004, respectively. Gross written premiums from new business excluding the
renewal rights acquisition were $8.3 million for the three months ended March
31, 2005, compared to $7.5 million for the same period ended 2004. Gross written
premiums from renewal business increased from $27.7 million for the three months
ended March 31, 2004 to $30.9 million for the same period in 2005. The increases
in renewal premiums were primarily due to the renewal rights acquisition
discussed previously. The increase in earned premiums in 2005 as compared to
2004 was primarily a result of the increase in gross written premiums in 2004.
The select markets' segment loss ratios were 63.7% and 65.9% for the three
months ended March 31, 2005 and 2004, respectively. The improvement in the loss
ratio was primarily the result of refinement of the underwriting profile and
improved terms and conditions over the past year. The select markets' segment
loss reserves were $227.8 million and $192.6 million as of March 31, 2005 and
2004, respectively.
The expense ratios for the select markets segment were 32.8% and 33.8% for the
three months ended March 31, 2005 and 2004, respectively. The decrease in the
expense ratio was primarily attributable to overall growth in premiums discussed
above.
The increase in investment income for the three months ended March 31, 2005, as
compared to the same period in 2004, was primarily the result of an increase in
invested assets due to positive cash flows plus increasing investment yields.
Invested assets were $312.5 million as of March 31, 2005, compared to $263.7
million as of March 31, 2004.
Public entity. The following table summarizes the public entity segment results
of operations for the three months ended March 31, 2005 and 2004:
Three Months Ended
March 31,
----------------------------
(in millions) 2005 2004
------------- -------------
Gross written premiums $ 18.2 $ 16.1
============= =============
Earned premiums 16.6 13.6
Losses and loss adjustment expenses 10.3 8.5
Underwriting expense 5.5 4.5
------------- -------------
Underwriting income 0.8 0.6
Investment income, net 1.1 0.3
------------- -------------
Income before taxes $ 1.9 $ 0.9
============= =============
Combined ratio 94.9% 96.0%
============= =============
21
The increase in gross written premiums for the three months ended March 31, 2005
as compared to 2004 was primarily the result of renewal business written in
2005. For the three months ended March 31, 2005, the public entity segment wrote
$15.0 million of renewal business compared to $10.5 million for the same period
in 2004. Additionally, during the three months ended March 31, 2005, the segment
wrote new business of approximately $3.2 million. For the three months ended
March 31, 2004, the segment wrote approximately $5.6 million of premium from new
business of which $2.3 million is attributable to a renewal rights agreement
entered into in the fourth quarter of 2003. The increase in earned premiums for
the three months ended March 31, 2005, as compared to the same period in 2004
was primarily attributable to premium growth during 2004.
Losses and loss adjustment expenses for the three months ended March 31, 2005
resulted in a slight improvement in the loss ratio of 62.0% compared to 62.8%
for the same period in 2004. Loss reserves for the public entity segment were
$66.7 million and $34.9 million as of March 31, 2005 and 2004, respectively.
The expense ratio for the three months ended March 31, 2005 was 32.9%, compared
to 33.2% for the same period in 2004. The slight decrease in the expense ratio
was due primarily to economies of scale from increased premium volume.
The increase in investment income for the three months ended March 31, 2005, as
compared to the same period in 2004, was primarily the result of an increase in
invested assets due to positive cash flows as well as higher investment yields.
Invested assets were $106.4 million as of March 31, 2005, compared to $53.2
million as of March 31, 2004.
Run-off lines. The Company has discontinued underwriting of certain lines of
business. The Company still is 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:
March 31,
-----------------------------------------
2005 2004
------------------- -------------------
(in millions) Gross Net Gross Net
--------- --------- --------- ---------
Environmental and asbestos:
Loss reserves, beginning of the period $176.4 $161.9 $219.5 $180.0
Incurred losses - - - -
Losses paid 3.3 3.1 5.8 3.0
--------- --------- --------- ---------
Loss reserves - environmental and
asbestos, end of the period 173.1 158.8 213.7 177.0
Other run-off lines 39.3 31.2 47.0 37.2
Net reserves ceded - retroactive
reinsurance contract - (41.4) - (42.4)
--------- --------- --------- ---------
Total reserves - run-off lines $212.4 $148.6 $260.7 $171.8
========= ========= ========= =========
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.
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 totaled $52.4 million as of March 31, 2005, and were
comprised of paid loss recoverables and case reserves of $28.3 million and
incurred but not reported claims of $24.1 million. Through the date of this
filing, none of these reinsurers have defaulted on their obligations to pay
22
claims due to the Company. The aforementioned reinsurance balances recoverable
are primarily due from insurance subsidiaries of Trenwick Group Ltd., an
insurance holding company, which filed an action to restructure its operations
under the U.S. Bankruptcy Code in August 2003. The balances are due from the
insurance subsidiaries of Trenwick Group Ltd, however, and not the holding
company itself. 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 these and other reinsurers could result
in the uncollectibility of certain balances and therefore materially impact the
financial results of the Company.
Pensions
Effective November 2003, the Company curtailed its pension plans. For the three
months ended March 31, 2005, the Company did not incur pension related expenses.
The Company does not believe that any significant funding of the pension plan
will be required during the current year. Management currently is evaluating
formal termination of the pension plans. Termination of the plans may result in
additional expense being incurred by the Company. However, as of this time,
management is unable to estimate the additional expense, if any.
Related Party Transactions
The discussion of related party transactions is included in "Note 11 - Related
Party Transactions" in the Notes to the Financial Statements, included in Item 1
"Consolidated Financial Statements."
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, 2005, consolidated net cash provided by
operating activities was $53.6 million, compared to $14.9 million for the same
period in 2004. The increase in cash flows from operating activities for the
three months ended March 31, 2005 as compared to 2004 was primarily attributable
to improved underwriting results. Additionally, during the three months ended
March 31, 2005, the Company received a tax refund of $8.1 million. For the same
period in 2004, the Company paid taxes in the amount of $11.5 million.
The Company has access to various liquidity sources including holding company
investments and cash, undrawn capacity under its revolving credit facility and
access to the debt and equity capital markets. Management believes that the
Company has sufficient liquidity to meet its needs.
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, 2004 that the Company filed with the
Securities and Exchange Commission on March 14, 2005 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 "Consolidated Financial Statements."
23
Critical Accounting Policies
Refer to "Critical Accounting Policies" in the Company's Annual Report on Form
10-K for the year ended December 31, 2004 that the Company filed with the
Securities and Exchange Commission on March 14, 2005 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 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, 2005, the Company received payments of $0.5 million on this
contract. Gains/losses 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, 2005 was $1.6 million,
compared to $0.8 million as of March 31, 2004.
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, 2005.
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. During the three months
ended March 31, 2005 and 2004, the Company did not incur any other than
temporary impairment losses in its investment portfolio. For the three months
ended March 31, 2005, the Company incurred a decrease in its unrealized gains of
$17.9 million, net of tax, due to increasing market interest rates and equity
liquidations. Interest rates increased dramatically in the short and mid-term
sections of the yield curve. Six-month yields increased 54 basis points, the
two-year increased 71 basis points and the five-year increased 56 basis points.
The Argonaut Group fixed income portfolio duration was approximately 3.8 years
as of the beginning of 2005 and was primarily sensitive to changes in the
five-year rate. The Company considers various factors when considering if a
decline in the fair value of an equity security is other than temporary,
including but not limited to, the length of time and magnitude of the unrealized
loss; the volatility of the investment; analyst recommendations and price
24
targets; opinions of the Company's external investment advisors; market
liquidity; and the Company's intentions to sell or ability to hold the
investments. Management has the ability and intent to hold these investments
until such time as their value recovers. Based on an evaluation of these
factors, the Company has concluded that the declines in the fair values of the
Company's investments in equity and fixed income securities as of March 31, 2005
are temporary.
Management has assessed these risks and believes that there have been no
material changes since December 31, 2004.
Item 4. Controls and Procedures
Under the supervision and with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, management of the Company has
evaluated the effectiveness of the design and operation of the Company's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934) as of March 31, 2005. In designing
and evaluating the Company's disclosure controls and procedures, the Company and
its management recognize that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving the
desired control objectives, and the Company's management necessarily was
required to apply its judgment in evaluating and implementing possible controls
and procedures. Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that the Company's disclosure controls and
procedures were effective at the reasonable assurance level to ensure that
information required to be disclosed by the Company in the reports it files or
submits under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commission's
rules and forms.
There was no change in the Company's internal control over financial reporting
that occurred during the quarter ended March 31, 2005 that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting. The Company reviews its disclosure controls
and procedures, which may include its internal controls over financial reporting
on an ongoing basis, and may from time to time make changes aimed at enhancing
their effectiveness and to ensure that the Company's systems evolve with its
business.
25
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
Refer to Part I, Item 3 - "Legal Proceedings" in the Company's Annual Report on
Form 10-K for the year ended December 31, 2004 that the Company filed with the
Securities and Exchange Commission on March 14, 2005 for discussion of the
Company's pending legal proceedings.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
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
A list of exhibits filed herewith is contained on the Exhibit Index immediately
preceding such exhibits and is incorporated herein by reference.
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, Senior Vice President and Treasurer
(principal financial and accounting officer)
/s/ Byron L. LeFlore, Jr.
- -------------------------
Byron L. LeFlore, Jr.
General Counsel, Senior Vice President and Secretary
May 10, 2005
27
EXHIBIT INDEX
Exhibit
No. Description
12.1 Statement of Computation of Ratio of Earnings to Fixed
Charges and Preferred Stock Dividends
31.1 Rule 13(a) - 14(a)/15(d) - 14(a) Certification of Chief
Executive Officer
31.2 Rule 13(a) - 14(a)/15(d) - 14(a) Certification of Chief
Financial Officer
32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted 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,
--------------------- ---------------------------------------------------------
2005 2004 2004 2003 2002 2001 2000
--------- ---------- --------- --------- --------- ---------- ---------
(in millions, except ratios)
Earnings:
Income (loss) from continuing
operations before provision for
income taxes $ 25.0 $ 18.3 $ 60.7 $ 135.3 $(21.1) $ 3.3 $(129.2)
Add:
Fixed charges 4.9 3.2 15.6 12.3 2.6 2.9 2.3
--------- ---------- --------- --------- --------- ---------- ---------
Total earnings (loss) $ 29.9 $ 21.5 $ 76.3 $ 147.6 $(18.5) $ 6.2 $(126.9)
========= ========== ========= ========= ========= ========== =========
Fixed charges
Interest expense, net $ 3.8 $ 2.1 $ 11.0 $ 8.4 $ 0.4 $ 0.2 $ -
Preferred stock dividends 0.6 0.6 2.5 1.8 - - -
Rental interest factor 0.5 0.5 2.1 2.1 2.2 2.7 2.3
--------- ---------- --------- --------- --------- ---------- ---------
Total fixed charges $ 4.9 $ 3.2 $ 15.6 $ 12.3 $ 2.6 $ 2.9 $ 2.3
========= ========== ========= ========= ========= ========== =========
Ratio of earnings to fixed charges 6.1:1 6.7:1 4.9:1 12.0:1 (A) 2.1:1 (B)
========= ========== ========= ========= ========= ========== =========
(A) Earnings were inadequate to cover fixed charges by $21.1 million
(B) Earnings were inadequate to cover fixed charges by $129.2 million
29
Exhibit 31.1
Rule 13a-14(a)/15(d) - 14(a)
Certification of the Chief Executive Officer
I, Mark E. Watson III, President and Chief Executive Officer of Argonaut Group,
Inc., certify the following:
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
statement 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)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) 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. Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
c. 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
d. 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
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.
May 10, 2005
/s/ Mark E. Watson III
----------------------------
Mark E. Watson III
President and Chief Executive Officer
30
Exhibit 31.2
Rule 13a-14(a)/15(d) - 14(a)
Certification of the Chief Financial Officer
I, Mark W. Haushill, Senior Vice President, Chief Financial Officer and
Treasurer of Argonaut Group, Inc., certify the following:
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
statement 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)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) 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. Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
c. 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
d. 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
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.
May 10, 2005
/s/ Mark W. Haushill
----------------------------
Mark W. Haushill
Senior Vice President, Chief Financial
Officer and Treasurer
31
Exhibit 32.1
Certification of CEO Pursuant to
18 U.S.C. Section 1350,
as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
In connection with the Quarterly Report on Form 10-Q of Argonaut Group, Inc.
(the "Company") for the three months ended March 31, 2005 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), Mark E
Watson III, as President and Chief Executive Officer of the Company, hereby
certifies, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to the ss. 906 of
the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:
1. The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
CERTIFIED this 10th day of May, 2005.
/s/ Mark E. Watson III
----------------------------
Mark E. Watson III
President and Chief Executive Officer
32
Exhibit 32.2
Certification of CFO Pursuant to
18 U.S.C. Section 1350,
as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
In connection with the Quarterly Report on Form 10-Q of Argonaut Group, Inc.
(the "Company") for the three months ended March 31, 2005 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), Mark W.
Haushill, as Senior Vice President, Chief Financial Officer and Treasurer of the
Company, hereby certifies, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant
to the ss. 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his
knowledge:
1. The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
CERTIFIED this 10th day of May, 2005.
/s/ Mark W. Haushill
----------------------------
Mark W. Haushill
Senior Vice President, Chief Financial
Officer and Treasurer
33