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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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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, 2003
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to ___________
Commission file number: 0-14950
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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, 78216
San Antonio, Texas
(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 13, 2003.
Title Outstanding
Common Stock, par value $0.10 per share 21,608,351
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ARGONAUT GROUP, INC.
TABLE OF CONTENTS
Page No.
--------
Part I. FINANCIAL INFORMATION:
Item 1. Condensed Consolidated Financial Statements:
Consolidated Balance Sheets
March 31, 2003 and December 31, 2002 .................. 3
Consolidated Statements of Operations
Three months ended March 31, 2003 and 2002 ............ 4
Consolidated Statements of Comprehensive Income
Three months ended March 31, 2003 and 2002 ............ 5
Consolidated Statements of Cash Flow
Three months ended March 31, 2003 and 2002 ............ 6
Notes to Condensed Consolidated Financial Statements .. 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations ............ 14
Item 3. Market Risks ............................................. 22
Item 4. Controls and Procedures .................................. 22
Part II. OTHER INFORMATION:
Item 1. Legal Proceedings ........................................ 23
Item 2. Changes in Securities and Use of Proceeds ................ 23
Item 3. Default Upon Senior Securities ........................... 23
Item 4. Submission of Matters to a vote of Security Holders ...... 23
Item 5. Other Information ........................................ 23
Item 6. Exhibits and Reports on Form 8-K ......................... 24
Signatures ........................................................... 25
2
Part I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in millions)
March December
31, 2003 31, 2002
----------- ----------
(Unaudited)
Assets:
Investments:
Fixed maturities, at fair value
(cost: 2003 - $918.4; 2002 - $850.7) $ 963.2 $ 894.1
Equity securities, at fair value
(cost: 2003 - 147.7; 2002 - $149.2) 226.9 237.1
Other long-term, at fair value
(cost: 2003 - $10.9; 2002 - $10.8) 10.2 10.0
Short-term investments, at fair value
(cost: 2003 - $49.6; 2002 - $40.1) 49.6 40.1
----------- ----------
Total investments 1,249.9 1,181.3
----------- ----------
Cash and cash equivalents 88.2 77.4
Accrued investment income 11.4 13.0
Premiums receivable 212.8 221.6
Reinsurance recoverable 476.1 470.1
Notes receivable 51.1 --
Goodwill 105.7 105.7
Deferred federal income tax asset, net 5.7 20.0
Deferred acquisition costs, net 57.1 54.7
Other assets 78.3 65.1
----------- ----------
Total assets $ 2,336.3 $ 2,208.9
=========== ==========
Liabilities and Shareholders' Equity:
Reserves for losses and loss adjustment expenses $ 1,312.2 $ 1,281.6
Unearned premiums 293.5 284.9
Funds held 167.6 163.6
Deferred gain, retroactive reinsurance 41.3 40.0
Note payable 18.0 --
Income taxes payable, net 10.2 1.5
Accrued expenses and other liabilities 101.3 109.6
----------- ----------
Total liabilities 1,944.1 1,881.2
----------- ----------
Shareholders' equity:
Preferred stock -$0.10 par, 5,000,000 shares
authorized Series A mandatory convertible
preferred stock - 2,953,310 and 0 shares issued
and outstanding at March 31, 2003 and
December 31, 2002 0.3 --
Common stock - $0.10 par, 35,000,000 shares
authorized; 21,602,082 shares issued and
outstanding at March 31, 2003 and December
31, 2002 2.2 2.2
Additional paid-in capital 131.5 96.4
Retained earnings 179.5 145.9
Deferred stock compensation (1.5) (1.7)
Accumulated other comprehensive income 80.2 84.9
----------- ----------
Total shareholders' equity 392.2 327.7
----------- ----------
Total liabilities and shareholders' equity $ 2,336.3 $ 2,208.9
=========== ==========
See accompanying notes.
3
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in millions, except per share amounts)
(Unaudited)
Three Months Ended
March 31,
----------------------------
2003 2002
------------ ------------
Premiums and other revenue:
Earned premiums $ 124.1 $ 84.6
Net investment income 11.3 13.3
Realized investment gains, net 56.0 8.1
------------ ------------
Total revenue 191.4 106.0
Expenses:
Losses and loss adjustment expenses 87.3 62.6
Underwriting, acquisition, and insurance
expense 47.4 32.6
------------ ------------
Total expenses 134.7 95.2
------------ ------------
Income before income taxes 56.7 10.8
Provision for income taxes 23.1 3.3
------------ ------------
Net income $ 33.6 $ 7.5
============ ============
Income per common share:
Basic $ 1.55 $ 0.35
============ ============
Diluted $ 1.55 $ 0.34
============ ============
Dividends declared per common share: $ -- $ 0.15
============ ============
Weighted average common shares:
Basic 21,603,503 21,557,870
============ ============
Diluted 21,636,318 21,663,690
============ ============
See accompanying notes.
4
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in millions)
(Unaudited)
Three Months Ended
March 31,
----------------------------
2003 2002
------------ ------------
Net income $ 33.6 $ 7.5
Other comprehensive income (loss):
Unrealized gains (loss) on securities:
Gains arising during the period (9.0) 15.0
Reclassification adjustment for gains
included in net income or loss 1.7 (8.1)
------------ ------------
Other comprehensive income (loss) before tax (7.3) 6.9
Income tax expense (recoverable) related to
other comprehensive income (loss) (2.6) 2.4
------------ ------------
Other comprehensive income (loss), net of tax (4.7) 4.5
------------ ------------
Comprehensive income $ 28.9 $ 12.0
============ ============
See accompanying notes
5
ARGONAUT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(Dollars in millions)
(Unaudited)
Three Months Ended
March 31,
----------------------------
2003 2002
------------ ------------
Cash flows from operating activities:
Net income $ 33.6 $ 7.5
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization and depreciation 2.8 2.0
Deferred federal income tax benefit 9.6 2.9
Gains on sales of investments 1.6 (8.1)
Gains on sales of real estate (57.6) --
Change in:
Accrued investment income 1.6 1.7
Receivables 2.8 5.9
Unearned premiums on ceded reinsurance (10.6) (2.6)
Reserves for losses and loss adjustment
expenses 30.6 (4.8)
Unearned premiums 8.6 13.8
Other assets and liabilities, net 4.1 0.6
------------ ------------
Cash provided by operating activities 27.1 18.9
------------ ------------
Cash flows from investing activities:
Sales of fixed maturity investments 4.2 21.9
Maturities and mandatory calls of fixed
maturity investments 75.2 24.5
Sales of equity securities 1.7 11.1
Purchases of fixed maturity investments (148.7) (54.1)
Purchases of equity securities (0.7) (5.7)
Increase in short-term investments (9.6) 1.1
Sale of real estate 57.6 --
Notes receivable for real estate sale (51.1) --
Other, net 7.7 2.8
------------ ------------
Cash provided (used) by investing activities (63.7) 1.6
------------ ------------
Cash flows from financing activities:
Issuance of Series A mandatory convertible
preferred stock 35.4 --
Receivable for issuance of preferred stock (6.0) --
Note payable 18.0 --
Payment of cash dividend -- (3.2)
------------ ------------
Cash provided (used) by financing activities: 47.4 (3.2)
------------ ------------
Change in cash and cash equivalents 10.8 17.3
Cash and cash equivalents, beginning of period 77.4 14.0
------------ ------------
Cash and cash equivalents, end of period $ 88.2 $ 31.3
============ ============
Additional disclosure:
Income taxes paid $ -- $ 0.4
============ ============
See accompanying notes
6
ARGONAUT GROUP, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 - Basis of Presentation
The accompanying Condensed Consolidated Financial Statements of Argonaut Group,
Inc. and Subsidiaries (collectively "Argonaut Group" or "the Company") have been
prepared in conformity with accounting principles generally accepted in the
United States of America (GAAP) for interim financial information and with the
instructions for Form 10-Q and Article 10 of Regulation S-X. Certain financial
information that is normally included in annual financial statements, including
certain financial statement footnotes, prepared in accordance with GAAP, is not
required for interim reporting purposes and has been condensed or omitted. These
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Annual Report on Form
10-K for the year ended December 31, 2002 filed with the Securities and Exchange
Commission.
The interim financial data as of March 31, 2003 and 2002 and for the three
months ended March 31, 2003 and 2002 is unaudited. However, in the opinion of
management, the interim data include all adjustments, consisting of normal
recurring accruals, necessary for a fair statement of the Company's results for
the interim periods. The operating results for the interim periods are not
necessarily indicative of the results to be expected for the full year. All
significant intercompany amounts have been eliminated. Certain amounts
applicable to prior periods have been reclassified to conform to the
presentation followed in 2003.
The balance sheet at December 31, 2002 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by GAAP for complete financial statements.
Note 2 - Recently Issued Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 supersedes Emerging
Issues Task Force Issue No. 94-3. SFAS No. 146 requires that the liability for a
cost associated with an exit or disposal activity be recognized when the
liability is incurred, not at the date of an entity's commitment to an exit or
disposal plan. The provisions of SFAS No. 146 are effective for exit or disposal
activities initiated after December 31, 2002. In the first quarter of 2003, the
Company restructured Argonaut Insurance Company and was accounted for in
accordance with SFAS No. 146. With the elimination of non-strategic products,
Argonaut Insurance Company has reduced its workforce by nine employees as of
March 31, 2003, and anticipates the reduction of an additional 68 employees over
the remainder of the year. Severance and outplacement costs of $0.9 million were
recorded for these employees terminating within 60 days of the communication
date of their termination. The Company will expense ratably an additional $0.5
million in restructuring costs for employees who have been notified of their
termination but whose termination extends beyond 60 days from the termination
communication date over the employees service period. Additionally, the Company
closed two offices at a total cost of $0.1 million. Any additional costs
associated with the restructuring will be recorded as incurred in the second and
third quarters of 2003.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosures." SFAS No. 148 establishes alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. In addition, the statement amends the
disclosure requirements of SFAS No. 123, "Accounting for Stock-Based
Compensation" to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. SFAS No. 148
is effective for financial statements for fiscal years ending after December 15,
2002. The Company adopted the provisions of SFAS No.
7
148 relating to pro forma reporting effective December 2002. The Company has not
made a determination regarding accounting for stock-based compensation on the
fair value method, but does not anticipate a change in methodology to have a
material impact on its consolidated financial position, results of operations or
cash flows.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46.) It requires that the assets, liabilities
and results of the activity of variable interest entities be consolidated into
the financial statements of the company that has controlling financial interest.
It also provides the framework for determining whether a variable interest
entity should be consolidated based on voting interest or significant financial
support provided to it. FIN 46 is effective July 1, 2003, and is not expected to
have a material impact on the Company's consolidated financial position, results
of operations or cash flows.
Note 3 - Preferred Stock
On March 31, 2003, the Company sold 2,453,310 shares of Series A Mandatory
Convertible Preferred Stock ("the preferred shares") at an offering price of $12
per share. The preferred shares were sold to one investor. The Company received
gross proceeds of approximately $29.4 million from this sale. The proceeds were
contributed to a subsidiary, Argonaut Insurance Company, to increase its
statutory surplus.
On March 31, 2003, the Company entered into an agreement with an investor to
sell an additional 500,000 of the preferred shares at an offering price of $12
per share. The offering funded April 15, 2003, with the Company receiving gross
proceeds of $6.0 million. The proceeds of this private placement were used to
repay a portion of a note payable (see note 10). Total proceeds from the
issuance of the preferred shares were $35.4 million.
The preferred shares are convertible at any time at the option of the holder at
an initial conversion price of $12 per share. Any outstanding preferred shares
will automatically convert into common shares on the tenth anniversary of the
issuance. The preferred shares are senior to the common shares in regard to
dividend and liquidation events.
The preferred shares will initially pay a 7 percent dividend on a quarterly
basis. The dividend is cumulative, and is payable when declared by the board of
directors. The dividend rate is subject to certain adjustments based upon the
Company's A.M. Best rating and Risk Based Capital level. Under the terms of the
private placement, the Company has agreed not to pay dividends to common
shareholders for a period of two years.
The holders of the preferred shares will be entitled to vote on an as-converted
basis on all matters submitted for a vote of the Argonaut Group common
shareholders. In the event the dividends payable on the preferred shares are in
arrears in an amount equal to at least two quarterly dividends, the holders of
the preferred shares will have the exclusive right, voting as a separate class,
to elect two directors of the Company.
Note 4 - Sale of Real Estate Holdings
On March 20, 2003, AGI Properties, Inc., a subsidiary of Argonaut Insurance
Company, sold a parcel of real estate in Torrance, California for approximately
$24.0 million. AGI Properties, Inc. received $4.8 million in cash and issued a
note receivable for the remainder, which is secured by the property. The note is
due November 30, 2004 and bears interest at 3.5 percent annually. The principal
and interest payments are due quarterly. The sale of this property met full gain
recognition under SFAS No. 66, "Accounting for Real Estate Sales" and resulted
in a pre-tax realized gain of $21.9 million.
On March 31, 2003, AGI Properties, Inc. sold certain parcels of real estate
located in Los Angeles and Goleta, California for $40.0 million under three
separate transactions with the same third party. For the three sales, AGI
Properties, Inc. received a total of $8.0 million in cash and issued total notes
receivable for the remaining $32.0 million. The notes receivable are secured
through a first lien deed of trust on the respective properties sold. The notes
bear interest at a floating rate of LIBOR plus 4 percent and are capped at 6
percent. Of the three notes, one
8
note in the amount of approximately $4.0 million was paid in full in April 2003.
The two remaining notes require monthly interest payments during 2003 with the
principal due upon maturity of September 30, 2004. The sales of these properties
met full gain recognition under SFAS No. 66 and resulted in a pre-tax gain of
$35.7 million.
Note 5 - 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, 2003 and 2002:
Three Months Ended
March 31,
----------------------------
(Dollars in millions except per share data) 2003 2002
------------ ------------
Net income $ 33.6 $ 7.5
============ ============
Weighted average shares-basic 21,603,503 21,557,870
Effect of dilutive securities:
Series A mandatory convertible
preferred stock 32,815 --
Stock options -- 105,820
------------ ------------
Weighted average shares-diluted 21,636,318 21,663,690
============ ============
Net income per common share-basic $ 1.55 $ 0.35
Net income per common share-diluted $ 1.55 $ 0.34
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 because the options' exercise
price was greater than the average market price of the common shares. These
options expire at varying times from 2004 through 2013. For the three months
ended March 31, 2002, options to purchase 383,300 shares of common stock at a
price ranging from $25.58 to $35.50 were not included in the computation of
diluted earnings per share because the options' exercise price was greater than
the average market price of the common shares. These options expire at varying
times from 2003 through 2012.
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, 2003, the Company had 69,366 shares of restricted stock issued
and outstanding. The restricted shares vest in equal annual installments over a
period of two to three years, subject to continued employment. The stock is not
issued until the vesting requirements are met. Thus, the stock does not carry
any voting or dividend rights. Compensation expense for restricted 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, 2003 and 2002, the Company recognized deferred stock compensation expense of
$0.2 million and $0, respectively.
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:
9
Three Months Ended
March 31,
----------------------------
(in millions, except per share amounts) 2003 2002
------------ ------------
Net income, as reported $ 33.6 $ 7.5
Add: Total deferred stock compensation expense
included in reported net income, net of taxes 0.1 --
Deduct: Total stock-based employee compensation
determined under fair value based methods for
all awards, net of tax (0.2) (0.1)
------------ ------------
Pro forma net income $ 33.5 $ 7.4
============ ============
Earnings per share
Basic - as reported $ 1.55 $ 0.35
Basic - pro forma $ 1.55 $ 0.34
Diluted - as reported $ 1.55 $ 0.34
Diluted - pro forma $ 1.55 $ 0.34
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 $26.2 million and
$35.9 million as of March 31, 2003 and 2002, respectively.
Reserves for Losses and Loss Adjustment Expenses
Three Months Ended
March 31,
----------------------------
(in millions) 2003 2002
------------ ------------
Net beginning of year $ 838.2 $ 929.5
Net reserves ceded under retroactive reinsurance
contracts (2.0) --
Add:
Losses and LAE incurred during current calendar
year, net of reinsurance
Current accident year 82.6 61.2
Prior accident years 4.7 1.4
------------ ------------
Losses and LAE incurred during calendar
year, net of reinsurance 87.3 62.6
Deduct:
Losses and LAE payments made during current
calendar year, net of reinsurance:
Current accident year 5.5 6.2
Prior accident years 55.7 59.0
------------ ------------
Losses and LAE payments made during current
calendar year, net of reinsurance: 61.2 65.2
Net reserves - end of period 862.3 926.9
Add:
Reinsurance recoverable on unpaid losses
& LAE, end of period 449.9 216.0
------------ ------------
Gross reserves - end of period $ 1,312.2 $ 1,142.9
============ ============
10
Note 8 - Business Segments
The Company is primarily engaged in writing property and casualty insurance. The
Company has classified its business into the following four continuing segments:
excess and surplus lines, specialty commercial, risk management (formerly
specialty workers' compensation) and public entity. Additionally, the Company no
longer underwrites certain coverages and classifies the results as run-off for
purposes of segment reporting. The Company considers many factors, including the
nature of the segment's insurance products, production sources, distribution
strategies and regulatory environment in determining how to aggregate operating
segments.
In evaluating the operating performance of its segments, the Company focuses on
core underwriting and investing results before the consideration of realized
gains or losses from the sales of investments. Realized investment gains
(losses) are reported as a component of the corporate and other segment, as
decision regarding the acquisition and disposal of securities resides with the
executive management of Company and is not under the control of the individual
business segments. Identifiable assets by segment are those assets used in the
operation of each segment. Identifiable assets are not assigned to run-off
lines.
Revenues and income before taxes for each reporting group were as follows:
Three Months Ended
March 31,
----------------------------
(in millions) 2003 2002
------------ ------------
Revenues:
Earned premiums
Excess & surplus lines $ 62.0 $ 28.7
Specialty commercial 28.1 24.9
Risk management 28.5 29.2
Public entity 5.5 1.8
Run-off lines -- --
------------ ------------
Total earned premiums 124.1 84.6
Net investment income
Excess & surplus lines 3.4 2.2
Specialty commercial 2.2 2.6
Risk management 7.3 8.4
Public entity 0.2 0.1
Run-off lines -- --
Corporate & other (1.8) --
------------ ------------
Total net investment income 11.3 13.3
Realized investment gains, net 56.0 8.1
------------ ------------
Total revenue $ 191.4 $ 106.0
============ ============
Income (loss) before income tax
Excess & surplus lines $ 7.9 $ 2.9
Specialty commercial 2.3 2.0
Risk management (8.0) (1.3)
Public entity 0.3 (0.1)
Run-off lines -- --
------------ ------------
Total segment income before taxes 2.5 3.5
Corporate & other (1.8) (0.8)
Net realized investment gains (losses) (1.6) 8.1
Net realized gains on sales of real estate 57.6 --
------------ ------------
Total income before income tax $ 56.7 $ 10.8
============ ============
11
The realized gains on the sale of the real estate holdings were allocated to the
risk management segment.
Identifiable assets for each reporting group were as follows:
March 31, December 31,
2003 2002
------------ ------------
Excess & surplus lines $ 551.4 $ 498.6
Specialty commercial 350.9 351.3
Risk management 1,402.4 1,324.5
Public entity 39.3 33.4
Run-off lines -- --
Corporate & other (7.7) 1.1
------------ ------------
Total $ 2,336.3 $ 2,208.9
============ ============
Note 9 - Underwriting, Acquisition and Insurance Expenses
Underwriting, acquisition and insurance expenses for the three months ended
March 31, 2003 and 2002 were as follows:
Three Months Ended
March 31,
----------------------------
(in millions) 2003 2002
------------ ------------
Commissions $ 21.9 $ 13.0
General Expenses 23.0 16.4
State assessments 2.0 1.8
Taxes, licenses and bureau fees 2.9 2.9
------------ ------------
49.8 34.1
Amortization (deferral) of policy
acquisition costs (2.4) (1.5)
------------ ------------
Total underwriting, acquisition and
insurance expense $ 47.4 $ 32.6
============ ============
Note 10 - Related Party Transactions
The Company utilizes Fayez Sarofim & Co. to manage a portion of its investment
portfolio, for which an investment advisory fee is calculated and payable
quarterly based upon the fair market value of the assets under management. 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, 2003, Fayez Sarofim & Co. managed $162.8 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, the Company borrowed $18.0 million from HCC Insurance
Holdings, Inc. (see note 3). The Company contributed $12.0 million of the
borrowing to Argonaut Insurance Company, $5.0 million is being held in escrow
for dividend payments related to the Series A Mandatory Convertible Preferred
Stock, and $1.0 million is being held by the Company for general corporate
purposes. The note payable is due March 31, 2006, bears interest at 12% annually
and is prepayable at the Company's option at anytime. The Company has the right
to repay the principal and accrued interest by issuing additional shares of the
Series A Mandatory Convertible
12
Preferred Stock to HCC Insurance Holdings, Inc., provided the necessary
regulatory approvals are received within 90 days of issuance of the note. The
note contains certain covenants, one of which requires repayment should the
Company enter into other debt agreements or issue additional shares of Series A
Mandatory Convertible Preferred Stock. Subsequent to March 31, 2003, the Company
repaid $6.0 million principal amount of the note, plus accrued interest in
conjunction with the issuance and proceeds of the additional preferred shares
discussed in note 3. On May 7, 2003, the Company received a waiver from HCC
Insurance Holdings, Inc. of the requirement to use proceeds from the Company's
issuance of its Floating Rate Junior Subordinated Deferrable Interest Debentures
due 2033 to repay the note payable (see note 11).
Note 11 - Subsequent Events
On April 25, 2003, Argonaut Group Statutory Trust, a recently-created
Connecticut statutory trust and wholly-owned subsidiary of the Company, agreed
to sell 15,000 Floating Rate Capital Securities (liquidation amount $1,000 per
Capital Security) to I-Preferred Term Securities II, Ltd. in a private sale for
$15.0 million. The Trust will use the proceeds from this sale, together with the
proceeds from its sale of Common Securities to the Company, to buy a series of
Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 from
the Company. The Debentures will have the same payment terms as the Capital
Securities.
The interest rate on the Debentures and the Capital Securities will be equal to
3-Month LIBOR plus 4.10% (not to exceed 12.5%), which rate will be reset
quarterly. The Debentures will be unsecured and will be subordinated in right of
payment to all of the Company's future senior indebtedness. Beginning in May
2008, the Company will have the right to redeem the Debentures, in whole or in
part, at a price equal to 100% of the principal amount of the Debentures, plus
accrued and unpaid interest to the date of redemption. The Company will also
have the right to redeem all of the Debentures before May 2008 upon the
happening of specified events at a price equal to 107.5% of the principal amount
of the Debentures, plus accrued and unpaid interest to the date of redemption.
The Company will use the net proceeds from the sale of the Debentures to
increase the statutory capital of its insurance company subsidiaries.
13
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, 2003 and 2002. It should be read in conjunction with the consolidated
financial statements and other data presented herein as well as with the
Management's Discussion and Analysis of Results of Operation and Financial
Condition contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002.
Forward Looking Statements
Management's Discussion and Analysis of Results of Operations and Financial
Conditions, Quantitative and Qualitative information about Market Risk and the
accompanying Condensed Consolidated Financial Statements (including the notes
thereto) contain "forward looking statements" which are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
The forward-looking statements are based on the Company's current expectations
and beliefs concerning future developments and their potential effects on the
Company. There can be no assurance that actual developments will be those
anticipated by the Company. Actual results may differ materially from those
projected as a result of significant risks and uncertainties, including
non-receipt of the expected payments, changes in interest rates, effect of the
performance of financial markets on investment income and fair values of
investments, development of claims and the effect on loss reserves, accuracy in
projecting loss reserves, the impact of competition and pricing environments,
changes in the demand for the Company's products, the effect of general economic
conditions, adverse state and federal legislation and regulations, developments
relating to existing agreements, heightened competition, changes in pricing
environments, and changes in asset valuations. The Company undertakes no
obligation to publicly update any forward-looking statements as a result of
events or developments subsequent to the date of this Quarterly Report.
Risk-Based Capital
The Company's insurance subsidiaries are subject to Risk-Based Capital ("RBC")
under The Insurers Model Act. RBC is designed to measure the adequacy of capital
for an insurance company based on the inherent specific risks of each insurer.
RBC is calculated on an annual basis, in conjunction with statutory financial
filings with the departments of insurance in which the company transacts
business. At December 31, 2002, Argonaut Insurance Company's RBC was within the
Company Action Level Event. However, Argonaut Insurance Company requested from
the California Department of Insurance permission to report a parcel of its real
estate at its agreed upon sales price. The California Department of Insurance
granted Argonaut Insurance Company the permitted practice. Without the permitted
practice Argonaut Insurance Company's RBC would have been within the Regulatory
Action Level Event, which would have required the Company's corrective action
plan to be approved by the department of insurance. During the first quarter of
2003 this parcel of real estate was sold in accordance with the permitted
practice granted by the California Department of Insurance.
Pursuant to the requirements under the Company Action Level, Argonaut Insurance
Company submitted to the California Department of Insurance a Comprehensive Plan
of Action ("the Plan"). The Plan included an analysis of the conditions that
contributed to Argonaut Insurance Company's RBC condition; proposals to increase
the RBC ratio; projections of Argonaut Insurance Company's RBC ratio; and key
assumptions underlying the proposals. The Company submitted the Plan to the
California Department of Insurance on April 8, 2003.
During the three months ended March 31, 2003, the Company contributed $41.4
million in capital to Argonaut Insurance Company. Management believes that
profits generated during 2003, combined with capital raising initiatives during
the first three months of 2003, will be sufficient to increase Argonaut
Insurance Company's RBC ratio above the Company Action Level. If the Company's
actual results differ materially from the plan submitted to the California
Department of Insurance, Argonaut Insurance Company's RBC could fall within the
14
Company Action Level as of December 31, 2003, and therefore subject Argonaut
Insurance Company to increasing levels of regulatory actions. Additionally, a
decline of the statutory surplus may limit the growth opportunities of the
insurance companies and may result in the downgrading of the insurance
subsidiaries by the national rating agencies, potentially impacting the
Company's ability to write new business and retain existing insureds.
Results of operations
The following is a comparison of selected data from the Company's operations:
Three Months Ended
March 31,
----------------------------
(in millions) 2003 2002
------------ ------------
Gross written premiums $ 173.9 $ 122.8
============ ============
Earned premiums $ 124.1 $ 84.6
Net investment income 11.3 13.3
Realized investment gains, net 56.0 8.1
------------ ------------
Total revenue $ 191.4 $ 106.0
============ ============
Income before taxes 56.7 10.8
Provision for income taxes 23.1 3.3
------------ ------------
Net income $ 33.6 $ 7.5
============ ============
Combined ratio 108.5% 112.2%
============ ============
The increase in consolidated gross written premiums and earned premiums was
primarily attributable to new business written during the three months ended
March 31, 2003. For the three months then ended gross written premiums related
to new business were $100.9 million compared to $50.7 million for the same
period in 2002. The increase in new business was primarily attributable to a
renewal rights acquisition within the excess and surplus lines segment, which
was effective in May 2002. Renewal gross written premiums accounted for $81.9
million for the three months ended March 31, 2003, compared to $75.5 million for
the same period of 2002. The increase in renewal gross written premiums was
primarily attributable to rate increases.
The decline in consolidated net investment income was the result of lower yields
partially offset by higher invested balances due to the investment of positive
cash flows. Consolidated invested assets totaled $1,249.9 million and $1,167.7
million at March 31, 2003 and 2002, respectively.
Consolidated realized gains on the sale of investments increased to $56.0
million as of March 31, 2003, as compared to $8.1 million for the same period
ended 2002. The increase was primarily due to the gains on sales of three real
estate holdings. Total gains on sales of the real estate holdings were $57.6
million. Excluding the gains on the sale of real estate, the Company recorded a
realized loss of $1.6 million on the investment portfolio, primarily
attributable to recognizing other than temporary impairment on its equity
portfolio of $2.3 million.
The consolidated loss ratios were 70.3% and 73.9% for the three months ended
March 31, 2003 and 2002, respectively. The improvement in the loss ratios was
primarily attributable to the effects of rate increases implemented over the
past two years, which was partially offset by reserve strengthening of $5.0
million in the risk management segment (see discussion below).
The consolidated expense ratios were 38.2% and 38.3% for the three months ended
March 31, 2003 and 2002, respectively. The expense ratios were comparable due to
increased premiums volumes and cost containment, which offset increases in
underwriting expenses in the risk management segment (see discussion below).
The provision for income taxes increased due to the recognition of the gain on
sales of certain real estate
15
holdings. The provision for income taxes for the three months ended March 31,
2003, includes the provision for California state taxes of $5.0 million combined
with the provision for federal income tax of $18.1 million.
Segment Results
As of March 31, 2003, the Company's operations include four continuing business
segments: excess and surplus lines, specialty commercial, risk management
(formerly specialty workers' compensation) and public entity. In evaluating the
operating performance of its segments, the Company focuses on core underwriting
and investing results before the consideration of realized gains or losses from
the sales of investments. Realized investment gains (losses) are reported as a
component of the corporate and other segment, as decisions regarding the
acquisition and disposal of securities resides with the executive management of
Company and is 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, 2003 and 2002.
Three Months Ended
March 31,
-----------------------
(in millions) 2003 2002
---------- ----------
Gross written premiums $ 84.6 $ 40.9
========== ==========
Earned premiums 62.0 28.7
Losses and loss
adjustment expenses 38.5 17.9
Underwriting expense 19.0 10.1
---------- ----------
Underwriting income 4.5 0.7
Interest income, net 3.4 2.2
---------- ----------
Income before taxes $ 7.9 $ 2.9
========== ==========
Combined ratio 92.6% 97.5%
========== ==========
The increases in gross written premiums and earned premiums for the three months
ended March 31, 2003 was the result of new business and rate increases. For the
three months ended March 31, 2003, gross written premiums derived from new
business increased $42.9 million to $66.1 million, primarily due to business
written through the renewal rights acquisition of Fulcrum Insurance Company.
Renewal gross written premiums increased $4.2 million to $24.8 million for the
three months ended March 31, 2003 primarily due to rate increases. This trend is
a reflection of the current environment of the excess and surplus lines market,
in that the current year premium has a similar risk profile to expiring
policies, and is being written at higher rates. Partially offsetting these
increases were cancellations and endorsements which reduced gross written
premiums by approximately $3.4 million.
The excess and surplus lines segment's loss ratio improved to 62.0% for the
three months ended March 31, 2003, compared to 62.5% for the same period in
2002. The improvement is primarily attributable to a reduction of the current
year loss ratio, reflecting the effects of rate increases realized over the past
year. Loss reserves for the excess and surplus lines were $203.5 million as of
March 31, 2003, compared to $142.6 million as of March 31, 2002.
The expense ratio for the three months ended March 31, 2003 was 30.6% compared
to 35.0% for the same period in 2002. Increases in variable expenses, such as
commissions and premium taxes due to the increases in premiums, were offset by
economies of scale resulting from the increase in gross written premiums related
to fixed expenses.
Increases in net investment income were the result of an increase in invested
assets due to investment of positive cash flows over the past twelve months. Net
invested assets increased to $393.6 million as of March 31, 2003,
16
compared to $240.9 million as of March 31, 2002.
Specialty Commercial. The following table summarizes the specialty commercial
results of operations for the three months ended March 31, 2003 and 2002.
Three Months Ended
March 31,
-----------------------
(in millions) 2003 2002
---------- ----------
Gross written premiums $ 34.4 $ 29.8
========== ==========
Earned premiums 28.1 24.9
Losses and loss
adjustment expenses 19.5 17.7
Underwriting expense 8.5 7.8
---------- ----------
Underwriting income(loss) 0.1 (0.6)
Interest income, net 2.2 2.6
---------- ----------
Income before taxes $ 2.3 $ 2.0
========== ==========
Combined ratio 99.5% 102.3%
========== ==========
The increase in gross written premiums and earned premiums was primarily
attributable to rate increases and new business. For the three months ended
March 31, 2003, renewal premiums increased $5.8 million to $30.0 million due to
average rate increases of approximately 10%. Premiums related to new business
written increased from $5.5 million as of March 31, 2002 to $6.9 million for the
same period in 2003. Partially offsetting these increases were reductions in
premiums of approximately $2.5 million due to cancellations and endorsements.
The specialty commercial segment's loss ratio for the three months ended March
31, 2003 was 69.4%, compared to 70.9% for the same period in 2002. Improvement
in the loss ratio was primarily attributable to rate increases over the past
year. Additionally, improved underwriting standards and claims handling
procedures contributed to the improved loss ratio. The specialty commercial
segment's loss reserves were $177.1 million and $159.3 million as of March 31,
2003 and 2002, respectively.
The expense ratio for the specialty commercial segment was 30.1% for the three
months ended March 31, 2003, compared to 31.4% for the same period in 2002. The
continued improvement in the expense was primarily the result of increased
premium volumes and cost containment.
The decline in investment income for the three months ended March 31, 2003, as
compared to the same period in 2002, was primarily the result of lower
investment yields partially offset by an increase in invested assets due to
positive cash flows.
Risk Management (formerly Specialty Workers' Compensation). The following table
summarizes the results of operations for the risk management segment for the
three months ended March 31, 2003 and 2002.
17
Three Months Ended
March 31,
-----------------------
(in millions) 2003 2002
---------- ----------
Gross written premiums $ 43.6 $ 47.2
========== ==========
Earned premiums 28.5 29.2
Losses and loss
adjustment expenses 26.5 25.6
Underwriting expense 17.3 13.3
---------- ----------
Underwriting loss (15.3) (9.7)
Interest income, net 7.3 8.4
---------- ----------
Loss before taxes $ (8.0) $ (1.3)
========== ==========
Combined ratio 153.6% 133.5%
========== ==========
The decrease in gross written premiums and earned premiums was primarily
attributable to a decline in renewal premiums in the three months ended March
31, 2003 compared to the same period in 2002. Renewal gross written premiums for
the three months ended March 31, 2003 totaled $23.0 million compared to $28.7
million for the same period in 2002. Partially offsetting this decline was an
increase in new business of $2.1 million to a total of $20.6 million for the
three months ended March 31, 2003. The reduction in renewal gross written
premiums was the result of Argonaut Insurance Company exiting certain lines of
business during the first quarter of 2003, by electing to not renew certain
accounts.
Losses and loss adjustment expenses for the three months ended March 31, 2003
resulted in a loss ratio of 92.7%, compared to 87.9% for the same period in
2002. Losses and loss adjustment expenses reported in 2003 included $5.0 million
of adverse loss development in workers' compensation products the Company no
longer underwrites. Absent this reserve strengthening, the loss ratio improved
to 75.4%, primarily due to favorable development in the core workers'
compensation products. Loss reserves totaled $633.7 million and $611.8 million
as of March 31, 2003 and 2002, respectively.
The expense ratio was 60.9% for the three months ended March 31, 2003, compared
to 45.6% for the same period in 2002. Included in underwriting expense for the
three months ended March 31, 2003 was a restructuring charge of approximately
$1.0 million (see discussion below). Additionally, amortization of deferred
policy acquisition costs increased by $2.9 million due to a decline in unearned
premiums.
In March 2003, Argonaut Insurance Company began to restructure its operations to
concentrate on casualty risk management solutions for upper-middle market
accounts. With the elimination of non-strategic businesses, Argonaut Insurance
Company has reduced its workforce by nine employees as of March 31, 2003, and
anticipates the reduction of an additional 68 employees over the remainder of
the year. Severance and outplacement costs of $0.9 million were recorded for
these employees terminating within 60 days of the communication date of their
termination. The Company will expense ratably an additional $0.5 million in
restructuring costs for employees who have been notified of their termination
but whose termination extends beyond 60 days from the termination communication
date over the employees service period. Additionally, the Company closed two
offices at a total cost of $0.1 million. Any additional costs associated with
the restructuring will be recorded as incurred.
Public Entity. The following table summarizes the results of operations for the
public entity segment for the three months ended March 31, 2003 and 2002.
18
Three Months Ended
March 31,
-----------------------
(in millions) 2003 2002
---------- ----------
Gross written premiums $ 11.3 $ 4.9
========== ==========
Earned premiums 5.5 1.8
Losses and loss
adjustment expenses 3.6 1.3
Underwriting expense 1.8 0.7
---------- ----------
Underwriting (loss)
income 0.1 (0.2)
Interest income, net 0.2 0.1
---------- ----------
Income (loss) before taxes $ 0.3 $ (0.1)
========== ==========
Combined ratio 98.8% 112.7%
========== ==========
The increase in gross written premiums and earned premiums is primarily the
result of new business written in 2003. For the three months ended March 31,
2003, the public entity segment's new business was approximately $7.2 million.
Additionally, the segment wrote $4.1 million of renewal business, of which $0.5
million was the result of rate increases.
Losses and loss adjustment expenses for the three months ended March 31, 2003
resulted in a loss ratio of 65.4% compared to a 72.1% for the same period in
2002. Loss reserves for the public entity segment were $8.8 million and $6.7
million as of March 31, 2003 and December 31, 2002, respectively.
The expense ratio for the three months ended March 31, 2003 was 33.4% compared
to 40.1% for the same period ended 2002. The decrease in the expense ratio
primarily resulted from operational efficiencies gained from increased volume
and streamlining of operations.
Run-off Lines. The Company has discontinued active underwriting of certain lines
of business. The Company is still obligated to pay losses incurred on these
lines which include general liability, asbestos and environmental liabilities
and medical malpractice policies written in past years. The lines currently in
run-off are characterized by long elapsed periods between the occurrence of a
claim and any ultimate payment to resolve the claim. The Company utilizes a
specialized staff dedicated to administer and settle these claims. Loss reserves
for the run-off lines were $289.2 million and $222.5 million as of March 31,
2003 and 2002, respectively.
The Company performs an extensive analysis of the run-off line reserves
semi-annually, traditionally in the second and fourth quarters. The Company
regularly monitors the activity of claims within the run-off lines, particularly
those claims related to asbestos and environmental liabilities. For the three
months ended March 31, 2003, the run-off lines did not experience adverse loss
development. Management believes the reserves for losses and loss development
expense is adequate based on current facts and circumstances.
Goodwill
The Company reviewed goodwill allocated to the risk management segment, due to
the restructuring of Argonaut Insurance Company combined with the sale of the
real estate holdings during the three months ended March 31, 2003. No impairment
of the goodwill balances was indicated. However, continued operating losses
within the risk management segment could result in an impairment of the goodwill
assigned to this reporting unit, resulting in a write down of the goodwill in
future periods. The Company will conduct its annual review of goodwill
impairment as of the third quarter 2003.
Reinsurance
Certain of the Company's reinsurance carriers have experienced deteriorating
financial condition or have been
19
downgraded by rating agencies. Amounts due from such reinsurers on paid claims
and case reserves totaled $27.5 million. Amounts due from such reinsurers on
incurred but not reported claims totaled $28.8 million. Through the date of this
filing, the reinsurers have not defaulted on their obligations to pay claims due
to the Company. The Company will continue to monitor these reinsurers; however,
to date, the Company has not received any indication that the reinsurers will
fail to honor their obligations under the reinsurance agreements. It is possible
that future financial deterioration of such reinsurers could result in the
uncollectibility of certain balances and therefore impact the financial results
of the Company.
On March 31, 2003, Colony Insurance Company entered into a quota share
reinsurance agreement with HCC Insurance Holdings, Inc. ("HCC"). Under the terms
of this agreement, the Company will cede 15% of the gross written premiums from
the excess and surplus lines segment to HCC. HCC will, in turn, assume 15% of
the losses from the excess and surplus lines segment. The Company will receive a
ceding commission to offset its acquisition costs related to these premiums. The
effect of this transaction will be to reduce gross written premiums, premiums
earned and losses and loss adjustment expenses. The agreement is subject to
approval by the Virginia Department of Insurance.
Liquidity
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, 2003, net cash provided by operating
activities was $27.1 million, compared to $18.9 million for the same period in
2002. The increase in cash inflows was primarily attributable to improved
underwriting results from rate increases implemented in 2002 and an increase in
cash inflows for premiums payments.
On March 31, 2003, the Company sold approximately 2.4 million shares of Series A
Mandatory Convertible Preferred Stock ("the preferred shares"). The preferred
shares were sold through a private placement to HCC. The Company received gross
proceeds of $29.4 million from HCC as a result of this sale. The proceeds were
used to increase the statutory surplus and RBC of Argonaut Insurance Company.
The preferred shares are convertible at any time into common stock at the option
of the holder at an initial conversion price of $12.00. Any outstanding
preferred shares will automatically convert into common shares on the tenth
anniversary of the issuance. The preferred shares will initially pay a 7 percent
dividend on a quarterly basis. The dividend rate is subject to certain
adjustments based upon the Company's A.M. Best rating and Risk Based Capital
level. The holders of the preferred shares will be entitled to vote on an
as-converted basis on all matters submitted for the vote of the Argonaut Group
common shareholders. Additionally, under the terms of the preferred shares, the
Company has agreed not to pay dividends to common shareholders for a period of
two years from March 31, 2003.
On March 31, 2003, the Company entered into an agreement with an investor to
issue an additional 500,000 preferred shares at an offering price of $12 per
share through a private placement. The sale closed on April 15, 2003, and the
Company used the gross proceeds of $6.0 million to repay a portion of the note
payable to HCC.
On March 31, 2003, the Company borrowed $18.0 million from HCC. The Company
contributed $12.0 million of the borrowing to Argonaut Insurance Company, $5.0
million is being held in escrow for dividend payments related to the Series A
Mandatory Convertible Preferred Stock, and $1.0 million was held by the Company
for general corporate purposes. The note payable is due March 31, 2006, bears
interest at 12% annually and is prepayable without penalty at the Company's
option at anytime. The note contains certain covenants, one of which requires
repayment should the Company enter into other debt agreements or issue
additional shares of Series A Mandatory Convertible Preferred Stock.
20
On March 20, 2003, AGI Properties, Inc., a subsidiary of Argonaut Insurance
Company, sold a parcel of real estate in Torrance, California for approximately
$24.0 million. AGI Properties, Inc. received $4.8 million in cash and issued a
note receivable for the remainder, which is secured by the property. The note is
due November 30, 2004 and bears interest at 3.5 percent annually. The principal
and interest payments are due quarterly. The sale of this property met full gain
recognition under SFAS No. 66, "Accounting for Real Estate Sales" and resulted
in a pre-tax realized gain of $21.9 million.
On March 31, 2003, AGI Properties, Inc. sold certain parcels of real estate
located in Los Angeles and Goleta, California for $40.0 million under three
separate transactions with the same third party. For the three sales, AGI
Properties, Inc. received a total of $8.0 million in cash and issued total notes
receivable for the remaining $32.0 million. The notes receivable are secured
through a first lien deed of trust on the respective properties sold. The notes
bear interest at a floating rate of LIBOR plus 400 basis points and are capped
at 6%. Of the three notes, one note in the amount of approximately $4.0 million
was paid in full in April 2003. The two remaining notes require monthly interest
payments during 2003 with the principal due upon maturity of September 30, 2004.
The sales of these properties met full gain recognition under SFAS No. 66 and
resulted in a pre-tax gain of $35.7 million.
On April 25, 2003, Argonaut Group Statutory Trust, a recently-created
Connecticut statutory trust and wholly-owned subsidiary of the Company, agreed
to sell 15,000 Floating Rate Capital Securities (liquidation amount $1,000 per
Capital Security) to I-Preferred Term Securities II, Ltd. in a private sale for
$15.0 million. The Trust will use the proceeds from this sale, together with the
proceeds from its sale of Common Securities to the Company, to buy a series of
Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 from
the Company. The Debentures will have the same payment terms as the Capital
Securities.
The interest rate on the Debentures and the Capital Securities will be equal to
3-Month LIBOR plus 4.10% (not to exceed 12.5%), which rate will be reset
quarterly. The Debentures will be unsecured and will be subordinated in right of
payment to all of the Company's future senior indebtedness. Beginning in May
2008, the Company will have the right to redeem the Debentures, in whole or in
part, at a price equal to 100% of the principal amount of the Debentures, plus
accrued and unpaid interest to the date of redemption. The Company will also
have the right to redeem all of the Debentures before May 2008 upon the
happening of specified events at a price equal to 107.5% of the principal amount
of the Debentures, plus accrued and unpaid interest to the date of redemption.
On May 7, 2003, the Company received a waiver from HCC of the requirement to use
the proceeds from the issuance of the Debentures to repay the HCC note described
above. The Company will use the net proceeds from the sale of the Debentures to
increase the statutory capital of its insurance company subsidiaries. The sale
is expected to close on May 15, 2003.
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, 2002 for further discussion on the
Company's liquidity.
Recent Accounting Pronouncements and Significant Accounting Policies
New Accounting Pronouncements
The discussion of the adoption and pending adoption of recently issued
accounting policies is included in "Note 2 - Recently Issued Accounting
Pronouncements" in the Notes to the Condensed Financial Statements, included in
Item 1.
Critical Accounting Policies
21
Refer to "Critical Accounting Policies" in the Company's Annual Report on Form
10-K for the year ended December 31, 2002 for information on accounting policies
that the Company considers critical in preparing its consolidated financial
statements. These policies include significant estimates made by management
using information available at the time the estimates were made. However, these
estimates could change materially if different information or assumptions were
used.
Item 3. Market Risks
The primary market risk exposures that result in an impact to the investment
portfolio relates to equity price changes and interest rate changes. The Company
does not hold any foreign currency risk or derivative instruments.
The Company holds a well-diversified portfolio of investments in common stocks
representing U.S. firms in industries and market segments ranging from small
market capitalization stocks to the Standard & Poors 500 stocks. Equity price
risk is managed primarily through the daily monitoring of funds committed to the
various types of securities owned and by limiting the exposure in any one
investment or type of investment. At March 31, 2003, investments in equity
securities included an investment in the common stock of Curtiss-Wright
Corporation which represents approximately 10% (pre-tax) of the total
shareholders' equity.
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 as issuers
may 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 rated municipal bonds, corporate bonds and preferred stocks).
Less than 1.0% of the fixed income portfolio is invested in bonds rated lower
than "BBB", with a 20-year maximum effective maturity. During the three months
ended March 31, 2003, the Company recognized other than temporary losses on the
investment portfolio of $2.3 million. During the three months ended March 31,
2002, there was no other than temporary impairment to the Company's investment
portfolio.
Management has assessed these risks and believes that there have been no
material changes since December 31, 2002.
Item 4. Controls and Procedures
In connection with the filing of this Form 10-Q, management, including the chief
executive officer and the 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 chief executive
officer and chief financial officer, concluded that the Company's disclosure
controls and procedures were effective as of March 31, 2003.
During the three month period ended March 31, 2003 and through the date of
filing, there were, a) no significant changes in 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, b) no significant changes in other
factors that could significantly affect internal controls, and c) no corrective
action required or taken with regard to significant deficiencies and material
weaknesses in such internal controls.
22
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, 2002 for discussion on the Company's
pending legal proceedings.
Item 2. Changes in Securities and Use of Proceeds
On March 31, 2003, the Company sold 2.4 million shares of Series A Mandatory
Convertible Preferred Stock ("preferred shares") in a private placement to one
investor. Additionally, the Company had an agreement to issue an additional
500,000 preferred shares to another investor the proceeds of which were received
on April 15, 2003. The preferred shares were sold for $12 per share, resulting
in gross proceeds to the Company of $35.4 million.
The preferred shares are convertible at any time at the option of the holder at
an initial conversion price of $12 per share. Any outstanding preferred shares
will automatically convert into common shares on the tenth anniversary of the
issuance. The preferred shares are senior to the common shares in regards to
dividend and liquidation events.
The sale of the preferred shares was not registered with the Securities and
Exchange Commission. The Company has agreed to use its best efforts to file a
shelf registration statement filed on Form S-3 relating to the resale of the
preferred shares with the Securities and Exchange Commission no later than May
30, 2003, and to have the registration statement declared effective no later
than July 29, 2003 and to keep the shelf registration continuously effective,
supplemented and/or amended.
The Company contributed the $29.4 million of the proceeds received on March 31,
2003 to Argonaut Insurance Company to increase its statutory surplus and RBC.
The Company used the $6.0 million received on April 15, 2003, to repay a portion
of the note payable that was outstanding as of March 31, 2003.
The Company estimates that expenses incurred associated with these transactions
were $1.2 million, consisting of investment banker fees of $0.8 million,
accounting fees of $0.2 million and legal fees of $0.2 million. The Company did
not make payments, direct or indirect, to directors, officers, general partners
of the Company or persons owning ten percent or more of any class of the
Company's securities. The net offering proceeds were estimated to be $34.2
million.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
23
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
A list of exhibits filed herewith is contained on the Exhibit Index
immediately preceding such exhibits and is incorporated herein by
reference.
(b) Reports on Form 8-K
On March 12, 2003, the Company filed a current report on Form 8-K
announcing the results of its asbestos and environmental reserve study, its
entering into an adverse loss development reinsurance agreement and the
results of its risk-based capital calculation.
On May 8, 2003, the Company filed a current report on Form 8-K announcing
its operating results for the three months ended March 31, 2003.
24
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)
By: /s/ Mark E. Watson III
---------------------------------------
Mark E. Watson III
Chief Executive Officer and President
(principal executive officer)
By: /s/ Mark W. Haushill
---------------------------------------
Mark W. Haushill
Chief Financial Officer,
Vice President and Treasurer
(principal financial and accounting
officer)
By: /s/ Byron L. LeFlore, Jr.
---------------------------------------
Byron L. LeFlore, Jr.
General Counsel, Vice President
and Secretary
May 15, 2003
25
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 quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a. designed such disclosure controls and procedures 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
quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date");
and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors:
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
CERTIFIED this 15th day of May, 2003.
/s/ Mark E. Watson III
-------------------------------------
Mark E. Watson III
President and Chief Executive Officer
26
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 quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a. designed such disclosure controls and procedures 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
quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date");
and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors:
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
CERTIFIED this 15th day of May , 2003.
/s/ Mark W. Haushill
-------------------------------------
Mark W. Haushill
Vice President
Chief Financial Officer and Treasurer
27
EXHIBIT INDEX
Exhibit
No. Description
- ------- -----------
3.1 Composite Copy of Certificate of Incorporation of Argonaut Group,
Inc., including Certificate of Designations, Preferences and Rights
of Series A Mandatory Convertible Preferred Stock.
3.2 Amended and Restated Bylaws of Argonaut Group, Inc.
10.1 Quota Share Reinsurance Agreement, dated as of March 31, 2003, by and
among Colony Insurance Company, Colony National Insurance Company,
Colony Specialty Insurance Company and Houston Casualty Company.
10.2 Subscription Agreement, dated as of March 12, 2003, by and between
Argonaut Group, Inc. and HCC Insurance Holdings, Inc.
10.3 Amendment No. 1, dated as of March 31, 2003 to Subscription Agreement
by and between Argonaut Group, Inc. and HCC Insurance Holdings, Inc.
10.4 Registration Rights Agreement, dated as of March 31, 2003, by and
among Argonaut Group, Inc. and the other parties identified therein.
10.5 Promissory Note, dated March 31, 2003, in the principal amount of
$18,000,000 payable by Argonaut Group, Inc. to HCC Insurance
Holdings, Inc.
10.6 Letter Agreement, dated May 7, 2003, by and between Argonaut Group,
Inc. and HCC Insurance Holdings, Inc.
99.1 Certificate of the Chief Executive Officer and the Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
28