| ALLEGHANY CORP /DE Item 1A Risk Factors |
| We face risks from our property and casualty and surety and fidelity insurance businesses and our investments in debt and equity securities |
| Some of what we believe are our more significant risks are discussed below; however, they are not the only risks that we face |
| Our businesses may also be adversely affected by risks and uncertainties not currently known to us or that we currently deem immaterial |
| The reserves for losses and LAE of our insurance operating units are estimates and may not be adequate, which would require them to establish additional reserves |
| Gross reserves for losses and LAE reported on our balance sheet as of December 31, 2005 were approximately dlra2dtta6 billion |
| These loss and LAE reserves reflect our best estimates of the cost of settling all claims and related expenses with respect to insured events that have occurred |
| Reserves do not represent an exact calculation of liability, but rather an estimate of what management expects the ultimate settlement and claims administration will cost for claims that have occurred, whether known or unknown |
| The major assumptions about anticipated loss emergence patterns are subject to unanticipated fluctuation |
| These reserve estimates, which generally involve actuarial projections, are based on management’s assessment of facts and circumstances currently known and expected future trends in claims severity and frequency, inflation, judicial theories of liability, reinsurance coverage, legislative changes and other factors |
| The inherent uncertainties of estimating reserves are greater for certain types of liabilities, where long periods of time elapse before a definitive determination of liability is made and settlement is reached |
| In periods with increased economic volatility, it becomes more difficult to accurately predict claim costs |
| Reserve estimates are continually refined in an ongoing process as experience develops and further claims are reported and settled |
| Adjustments to reserves are reflected in the results of the periods in which the adjustments are made |
| Because setting reserves is inherently uncertain, we cannot assure you that our current reserves will prove adequate in light of subsequent events |
| Should our insurance operating units need to increase their reserves, our pre-tax income for the period would decrease by a corresponding amount |
| Although current reserves reflect our best estimate of the costs of settling claims, we cannot assure you that our reserve estimates will not need to be increased in the future |
| Because our insurance operating units are property and casualty insurers, we face losses from natural and man-made catastrophes |
| Property and casualty insurers are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition |
| Catastrophe losses have had a significant impact on our results |
| For example, pre-tax catastrophe losses, net of reinsurance and reinsurance reinstatement premiums, at our insurance operating units were dlra304dtta6 million in 2005, dlra153dtta3 million in 2004 and dlra18dtta7 million in 2003 |
| RSUI’s 2005 results were impacted by dlra287dtta3 million of pre-tax losses from the 2005 hurricanes, net of reinsurance recoverables and reinsurance reinstatement premiums of dlra26dtta2 million |
| Several states (or underwriting organizations of which our insurance operating units are required to be members) may increase their mandatory assessments as result of these recent catastrophes and other events, and we may not be able to fully recoup these increased costs |
| 22 _________________________________________________________________ [73]Table of Contents Catastrophes can be caused by various events, including hurricanes, other windstorms, earthquakes and floods, as well as terrorist activities |
| The incidence and severity of catastrophes are inherently unpredictable |
| The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event |
| Most catastrophes are restricted to small geographic areas; however, hurricanes, other windstorms, earthquakes and floods may produce significant damage in areas that are heavily populated |
| The geographic distribution of AIHL’s insurance operating units subjects them to catastrophe exposure in the United States principally from hurricanes in the Gulf coast regions, Florida, the Mid-Atlantic, and Northeast, from other windstorms in the Midwest and Southern regions, and earthquakes in California, the Pacific Northwest region and along the New Madrid fault line in the Midwest regions |
| Catastrophes can cause losses in a variety of our property and casualty lines, and most of our past catastrophe-related claims have resulted from severe storms |
| It is therefore possible that a catastrophic event or multiple catastrophic events could produce significant losses and have a material adverse effect on our results of operations and financial condition |
| With respect to terrorism, to the extent that reinsurers have excluded coverage for terrorist acts or have priced this coverage at rates that are not practical, our insurance subsidiaries, particularly RSUI, do not have reinsurance protection and are exposed for potential losses as a result of any terrorist acts |
| To the extent an act of terrorism is certified by the US Secretary of Treasury, we may be covered under the Terrorism Act; however, the Terrorism Act provides for annual reductions in coverage with the termination of federal government participation in the terrorism insurance market on December 31, 2007 |
| Information regarding the Terrorism Act and its impact on our insurance operating units can be found on pages 18 and 19 of this Form 10-K Report |
| RSUI attempts to manage its exposure to catastrophe risk partially through the use of catastrophe modeling software |
| The failure of this software to accurately gauge and/or price catastrophe-exposed risks RSUI writes could have a material adverse effect on our financial condition or our results of operations |
| As part of its approach to managing catastrophe risk, RSUI has historically used a number of tools, including third party catastrophe modeling software, to help model potential losses |
| RSUI has used modeled loss scenarios to set its level of risk retention and help structure its reinsurance programs |
| Modeled loss estimates, however, have not accurately predicted RSUI’s ultimate losses with respect to recent hurricane activity |
| In the case of Hurricane Katrina, the modeled estimates significantly underestimated RSUI’s current estimate of ultimate losses due to a number of factors, the most significant of which was higher than expected damage to inland located risks |
| Accordingly, in an effort to better manage its accumulations of risk such that its loss exposure conforms to its established risk tolerances and fits within its reinsurance programs, RSUI is reviewing its catastrophe exposure management approach, including its modeling tools and its underwriting guidelines and procedures |
| Actions RSUI may take as a result of this review could end up reducing, possibly significantly, its writings in certain classes of catastrophe exposed business |
| Prior to completion of these actions, RSUI remains exposed to greater catastrophe risks than previously expected |
| 23 _________________________________________________________________ [74]Table of Contents If market conditions cause reinsurance to be more costly or unavailable, our insurance operating units may be required to bear increased risks or reduce the level of their underwriting commitments |
| As part of our overall risk and capacity management strategy, our insurance operating units purchase reinsurance for certain amounts of risk underwritten by them, especially catastrophe risks |
| Market conditions beyond their control determine the availability and cost of the reinsurance protection they purchase, which may affect the level of their businesses and profitability |
| For example, recent catastrophes and other events may limit the availability of, and further increase the cost of, reinsurance |
| The reinsurance facilities of our insurance operating units are generally subject to annual renewal |
| As a result, they may be unable to maintain their current reinsurance facilities or to obtain other reinsurance facilities in adequate amounts and at favorable rates |
| If our insurance operating units are unable to renew their expiring facilities or to obtain new reinsurance facilities, either their net exposures would increase or, if they are unwilling to bear an increase in net exposures, they would have to reduce the level of their underwriting commitments, especially catastrophe exposed risks |
| In particular, RSUI’s current catastrophe and per risk reinsurance treaties expire on May 1, 2006 |
| If RSUI is unable to renew its expiring treaties or to obtain new reinsurance coverage at terms and at a price acceptable to it, either RSUI’s net exposures would increase going forward, which could increase the volatility of its results, or, if RSUI was unwilling to bear an increase in net exposures, the level of its underwriting commitments for catastrophe and non-catastrophe exposed risks would have to be reduced, which may reduce RSUI’s revenues and net income |
| In accordance with industry practice, catastrophe reinsurance contracts generally provide coverage for only two catastrophic events during a single coverage period, which is typically one year, and only for the second event if the insured pays a reinsurance reinstatement premium to restore coverage after the first event |
| If our insurance operating units use their catastrophic reinsurance contracts for two catastrophic events during a single coverage period, they will not have any reinsurance coverage available for losses incurred as a result of additional catastrophic events during that coverage period |
| We cannot guarantee that the reinsurers used by our insurance operating units will pay in a timely fashion, if at all, and, as a result, we could experience losses |
| Our insurance operating units purchase reinsurance by transferring, or ceding, part of the risk that they have underwritten to a reinsurance company in exchange for part of the premium received by our insurance operating units in connection with that risk |
| Although reinsurance makes the reinsurer liable to our insurance operating units to the extent the risk is transferred or ceded to the reinsurer, it does not relieve our insurance operating units of their liability to their policyholders |
| Reinsurers may not pay the reinsurance recoverables that they owe to our insurance operating units or they may not pay these recoverables on a timely basis |
| This risk may increase significantly if these reinsurers experience financial difficulties as a result of natural catastrophes and other events |
| Underwriting results and investment returns of some of the reinsurers used by our insurance operating units may affect their future ability to pay claims |
| Accordingly, we bear credit risk with respect to our insurance operating units’ reinsurers, and if they fail to pay, our financial results would be adversely affected |
| As of December 31, 2005, the amount due from reinsurers reported on our balance sheet was dlra1dtta6 billion, with dlra1dtta5 billion attributable to RSUI’s reinsurers |
| 24 _________________________________________________________________ [75]Table of Contents If RSUI’s Hurricane Katrina losses are greater than currently estimated, RSUI will not have reinsurance coverage for such losses |
| Based on RSUI’s current estimate of losses related to Hurricane Katrina, RSUI has exhausted its catastrophe reinsurance protection with respect to this event, meaning that it has no further catastrophe reinsurance coverage available should its Hurricane Katrina losses prove to be greater than currently estimated |
| Our insurance operating units are rated by AM Best, and a decline in these ratings could affect the standing of our insurance operating units in the insurance industry and cause their premium volume and earnings to decrease |
| Ratings have become an increasingly important factor in establishing the competitive position of insurance companies |
| AM Best’s ratings reflect its opinion of an insurance company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders |
| These ratings are subject to periodic review, and we cannot assure you that any of our insurance operating units will be able to retain those ratings |
| If the ratings of our insurance operating units are reduced from their current levels by AM Best, their competitive positions in the insurance industry could suffer and it would be more difficult for them to market their products |
| A significant downgrade could result in a substantial loss of business as policyholders move to other companies with higher claims-paying and financial strength ratings |
| The property and casualty insurance business is cyclical in nature, which may affect our financial performance |
| Historically, the financial performance of the property and casualty insurance industry has tended to fluctuate in cyclical periods of price competition and excess capacity (known as a soft market) followed by periods of high premium rates and shortages of underwriting capacity (known as a hard market) |
| Although an individual insurance company’s financial performance is dependent on its own specific business characteristics, the profitability of most property and casualty insurance companies tends to follow this cyclical market pattern |
| Further, this cyclical market pattern can be more pronounced in the excess and surplus market in which RSUI and Darwin primarily compete, than in the admitted insurance market |
| When the admitted insurance market hardens, the excess and surplus market hardens, and growth in the excess and surplus market can be significantly more rapid than growth in the standard insurance market |
| Similarly, when conditions begin to soften, many customers that were previously driven into the excess and surplus market may return to the admitted insurance market, exacerbating the effects of rate decreases |
| Since cyclicality is due in large part to the actions of our insurance operating units’ competitors and general economic factors, we cannot predict the timing or duration of changes in the market cycle |
| A significant amount of our assets is invested in debt securities and is subject to market fluctuations |
| Our investment portfolio consists substantially of debt securities |
| As of December 31, 2005, our investment in debt securities was approximately dlra1dtta6 billion, or 52dtta6 percent of our total investment portfolio |
| The fair market value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions |
| The fair market value of debt securities generally decreases as interest rates rise but investment income earned from future investments in debt securities will be higher |
| Conversely, if 25 _________________________________________________________________ [76]Table of Contents interest rates decline, investment income earned from future investments in debt securities will be lower but their fair market value will generally rise |
| In addition, some debt securities, such as mortgage-backed and other asset-backed securities, carry prepayment risk, or the risk that principal will be returned more rapidly or slowly than expected, as a result of interest rate fluctuations |
| Based upon the composition and duration of our investment portfolio at December 31, 2005, a 100 basis point increase in interest rates would result in a decrease in the fair value of our investments of approximately dlra61dtta5 million |
| The value of our investments in debt securities, and particularly investments in debt securities that are non-rated or rated below Baa/BBB, is subject to impairment as a result of deterioration in the credit-worthiness of the issuer |
| Although we attempt to manage this risk by diversifying our portfolio and emphasizing preservation of principal, our investments are subject to losses as a result of a general decrease in commercial and economic activity for an industry sector in which we invest, as well as risks inherent in particular securities |
| We invest some of our assets in equity securities, which may decline in value |
| We invest a portion of our investment portfolio in equity securities which are subject to fluctuations in market value |
| At December 31, 2005, our investments in equity securities were approximately dlra796dtta2 million, or 26 percent of our investment portfolio |
| We hold our equity securities as available for sale, and any changes in the fair value in these securities, net of tax, would be reflected in our accumulated other comprehensive income as a component of stockholders’ equity |
| At December 31, 2005, our equity portfolio had investment concentrations in the common stock of Burlington Northern Santa Fe Corporation, or “Burlington Northern,” a railroad holding company, and in certain energy sector businesses |
| At December 31, 2005, our Burlington Northern common stock holdings had a fair market value of dlra424dtta9 million, which represented 53dtta4prca of our equity portfolio, and our energy sector equity holdings had an aggregate fair market value of dlra194dtta9 million, which represented 24dtta5prca of our equity portfolio |
| These investment concentrations may lead to higher levels of short-term price volatility and variability in the level of unrealized investment gains or losses |