DORINCO REINSURANCE COMPANY NAIC GROUP CODE 0000 NAIC COMPANY CODE 33499 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - 2015 1. Overview This discussion provides an assessment by management of the current financial position, results of operations, cash flow and liquidity for Dorinco Reinsurance Company (Dorinco, the Company) for the year ended December 31, 2015. Information presented in this discussion supplements the financial statements, schedules, and exhibits in the 2015 Annual Statement. Dorinco is a wholly owned subsidiary of Liana Limited which is ultimately a wholly owned subsidiary of The Dow Chemical Company (Dow). Dorinco issues direct property and liability insurance policies to Dow and certain related companies, and participates in property and casualty reinsurance treaties covering Dow or unrelated parties with other insurance companies. 1.1. General Dorinco maintained its recent strong financial results in 2015, recording positive underwriting income and operating cash flow in a slow-to-moderategrowth economic year. In spite of the difficulties experienced in the global financial markets during 2015, Dorinco finished the year with positive investment income and solid realized capital gains during 2015, tempered by declines in the unrealized gains carried within the Company s investment portfolios. Overall, Dorinco s admitted assets decreased from $1.566 billion in 2014 to $1.536 billion in 2015, reflecting the impact of dividends paid to stockholders during the year and the aforementioned unrealized gains declines, largely offset by favorable underwriting and investment income earned, highlighted by continued growth in the Company s fixed income portfolio. Dorinco's main focus is to provide an efficient vehicle to Dow to manage its risks and to complement it with top quality profitable unrelated business. Page 1
I. FINANCIAL POSITION Dorinco's financial position at December 31 was as follows: ADMITTED ASSETS $MILLION 2015 2014 Bonds 920.1 889.6 Equity 227.2 286.7 Other Invested Assets 183.4 220.9 Cash/Short Term Investments 105.9 79.5 Premium Balances 54.4 61.0 Funds Held 5.5 8.1 Reinsurance Recoverable on Loss/LAE Payments 15.9 10.5 Net Deferred Taxes 13.1 0.2 Other Assets 10.7 9.4 TOTAL ASSETS 1,536.2 1,565.9 LIABILITIES Unpaid Losses/LAE/IBNR 851.5 844.3 Unearned Premiums 64.1 67.2 Current Federal Income Taxes Payable 34.1 28.8 Ceded Reinsurance Premium Payable 37.2 28.5 Dividends Declared and Unpaid 25.0 20.0 Funds Held Under Reinsurance Treaties 1.0 0.9 Provision for Reinsurance 2.4 3.3 Other Liabilities 6.9 38.1 TOTAL LIABILITIES 1,022.2 1,031.1 TOTAL POLICYHOLDER'S SURPLUS 514.0 534.8 LIABILITIES & SURPLUS 1,536.2 1,565.9 Page 2
IA. ASSETS Dorinco's 2015 admitted assets decreased $29.8 million as compared with 2014, declining 1.9% during the year. Cash and invested assets decreased by $40.2 million or 2.7% versus 2014 primarily due to dividends paid and decreases in the Company s equities portfolio. Unrealized gains in the portfolio decreased significantly due to the harvesting of certain realized gains and a deterioration of the Company s equity investments in the commodities and emerging market sectors. Positive cash flow from operations and investment income helped to mitigate the decline in the equities portfolio. The goal of Dorinco's investment policy is to maximize its long-term rate of return. Dorinco, via a service contract, utilizes the portfolio management services of Dow s Portfolio Investment group. To accomplish the above stated goal, a diversified investment portfolio consisting of fixed income, equities, and alternative investments is maintained. Overall, the Company s total return on its investment portfolio for 2015 was a decline of 0.5%, compared to a growth of 5.0% in 2014, as positive returns in the fixed income portfolio were eclipsed by negative returns in the Company s equity and alternative investment portfolios. The amortized cost of the fixed income portfolio increased by $30.5 million or 3.4% in 2015, as funds from bonds which matured and were sold or called during 2015 were invested in new fixed income investments, offset by a portion utilized for dividends and operations. For 2015, the fixed income portfolio generated a positive 0.8% rate of return. Looking into 2016, the path of interest rates will be highly dependent on the U.S. Federal Reserve (Fed) monetary policy which, in turn, is highly dependent on macroeconomic data. Due to improving data in the U.S., and the perception that inflation pressures may eventually re-emerge, the Fed raised the upper bound of the target rate to 0.50% in late 2015, the first change in the Fed Funds rate since 2008. The outlook for further rate hikes is highly data dependent and is therefore contingent upon economic data reported in the U.S. as well as economic and political conditions globally. The U.S. macroeconomic data continues to show slow but steady improvement. Forecasts suggest U.S. real GDP may grow at a rate of 2.2% in 2016, slightly lower than what was observed in 2015. The U.S. unemployment rate, currently at 4.9%, continues the trend of steady improvement and is within 50 basis points (bps) of the lowest unemployment rate seen in the prior expansion cycle. Inflation as measured by the Consumer Price Index (CPI), though higher relative to what was witnessed in 2015, remains subdued due to the effects of low energy prices. Excluding the effects of energy, core CPI continues to trend higher and is approaching 2.3% on a year-over-year basis, a pace not seen since early 2012. In early 2016, Fed forward guidance as communicated through the dot plot chart suggests the Fed may only raise rates one to two times in 2016 for a total of 25 to 50 bps of rate hikes. This outlook aligns well with current market expectations, flattening the yield curve in consideration of the slow and steady approach to the removal of accommodative monetary policy and downward pressure on yields due to extremely low yields in other developed markets. U.S. corporate credit spreads increased late in 2015 and the widening accelerated in early 2016. The widening was in response to concerns that economic activity was slowing at home and abroad. Depressed energy prices triggered some acute spread widening in the energy sector as credit metrics suffered across the sector as a result of lower revenues and margins. With oil prices rebounding to levels closer to $40 per barrel, the pressure has eased somewhat and spreads have tightened. Page 3
The market value of the Company s equity portfolio decreased by $59.5 million or 20.8% in 2015, versus 2014, primarily due to sales in accordance with a change in the Company s investment allocation strategy and market declines in the commodities and emerging markets sectors. Dorinco s domestic portfolio s rate of return totaled 0.2% in 2015, while the Company s emerging markets portfolio underperformed, returning a negative 12.7%. The Company s equities portfolio s overall rate of return totaled a negative 2.9% in 2015. The Company s expectation is that the total returns for the S&P 500 index will be in the range of five to eight percent for 2016 as earnings growth slows in line with sub 3% global GDP growth. U.S. Large Cap stocks were slightly positive in 2015 with the S&P 500 returning approximately 1%. U.S. Small Cap stocks underperformed with the Russell 2000 losing roughly 4% on the year. Given the current economic backdrop and concerns, the length of the economic recovery may make further upside unlikely; U.S. equities may be able to deliver only modest positive returns in 2016. The market is likely to be choppy as the world grapples with persistent terrorism risks, political changes, perceived weakness in Chinese markets and a glut of energy. The combination of lower oil and commodity prices, low to moderate labor cost pressures and low interest rates continue to be key enablers for continued, but somewhat muted, profit growth. Expected market headwinds continue to be a relatively weak Euro zone, sub-par emerging markets growth, and significant fluctuation in foreign exchange rates, which are changing the competitive dynamics among companies and nations. Emerging markets continue to struggle as their own growth rates decelerate and they are faced with increased capital outflows due to U.S. economic improvements. Given the higher degree of uncertainty in emerging geographies, their equity markets are expected to continue to underperform the U.S. equity markets. Fed policy makers, if faced with turbulence in markets, may elect to alter the expected path of interest rates to minimize the divergence with monetary policies in other major countries and lessen the pressure on risk-seeking assets. Dorinco s cash and short-term investments increased by $26.4 million in 2015. Dorinco utilizes temporary investments until investments that meet its long-term investment objectives can be acquired or anticipated dividends are paid. Dorinco s comparatively large short-term investments position at year end 2015 was maintained in anticipation of paying a $25 million stockholder s dividend declared in December, 2015. Receipt of approval for payment of the $25 million dividend was received from the Michigan Insurance Commissioner during the first quarter of 2016, and the dividend is expected to be paid in April, 2016. Other invested assets decreased by $37.6 million in 2015. Premium receipts for December insurance policy renewals, resulting in additional cash available at year-end, are bundled into a temporary loan and are recorded as an other invested asset. In the current year, premiums associated with certain of the December insurance policy renewals declined. The decrease in premiums, along with claims paid during the fourth quarter, decreased the funds available for a temporary loan in 2015, as compared to 2014. Additionally, Dorinco s conventional alternative assets portfolio declined by $9.1 million during 2015 largely due to market conditions. Net deferred tax assets increased by $12.9 million from 2014 to 2015. The increase in this balance was due primarily to sizeable decreases in the unrealized gains carried within the Company s investment portfolios. The decreases in unrealized gains resulted in a corresponding decrease in the balance of deferred tax liabilities available as an offset to the Company s Page 4
deferred tax assets. In 2014, the Company s deferred tax liabilities effectively offset the Company s deferred tax assets balance. Premium receivables and reinsurance recoverables decreased by a combined $3.8 million in 2015 versus 2014 largely due to the timing of payments (premium receivable balances are gross of ceded reinsurance premium payables of $37.2 million in 2015 and $28.5 million in 2014). IB. LIABILITIES Loss and loss expense reserves are stated at Dorinco's estimate of the ultimate loss, net of ceded reinsurance recoverables. Included as a reduction to unpaid loss reserves are $232.1 million of recoverables from affiliate Dorintal Reinsurance Limited. This balance is fully collateralized by a reinsurance trust. The amount of reserves related to reported claims for direct business is based upon a case-by-case estimate determined by the claims professionals employed by Dorinco. Other reserves on other business assumed are based on statements received from ceding companies. Loss and loss expense reserves are not discounted. The estimate of losses arising from claims which have not yet been reported (IBNR) to Dorinco is based upon management's best judgments; however, the ultimate liability may be in excess of or less than the amounts provided. All unpaid reserves reported and IBNR are certified annually by a qualified independent actuary. Activity with respect to loss and loss expense reserves for the last two years is detailed below: $MILLION 2015 2014 Unpaid Losses and Loss Expense at Beginning of Year Loss and Loss Expenses Incurred for Current Year Increase (Decrease) in Estimates for Prior Loss Years 844.3 840.9 136.5 147.5 (42.4) (20.8) Loss and LAE Payments Made in Current Year (87.1) (123.3) Unpaid Losses and Loss Expenses at End of Year 851.5 844.3 During 2015, Dorinco continued its review of outstanding reserves and, based on loss history, trends, claim reporting activity and analysis of existing claims, it was determined that reserves should be decreased, resulting in a decrease in estimates for prior years of $42.4 million. Unearned premiums decreased from $67.2 million in 2014 to $64.1 million in 2015, reflecting a decline in the net written premiums for the direct property and liability insurance policies issued to Dow. Page 5
IC. CAPITAL AND SURPLUS ACCOUNTS There has been no change to the capital stock or paid in and contributed surplus for the last two years. During 2015, the Board of Directors declared dividends of $25.0 million in May and $25.0 million in December, all payable to its parent, subject to approval from the Michigan Insurance Commissioner. Approval was subsequently received for each of the above. The May declared dividends were paid on June 10, 2015. The December declared dividends are anticipated to be paid in April, 2016. In 2015, the Company generated a profit after tax of $85.8 million from operations. This was more than offset by a decline in the unrealized value of Dorinco s investments, increased deferred tax assets nonadmitted, and the declaration of dividends, as described above. The combined offsetting items contributed to an overall decline in policyholders surplus of $20.8 million, or 3.9%, from $534.8 million at December 31, 2014, to $514.0 million at December 31, 2015. II. RESULTS FROM OPERATIONS Dorinco produced net income of $85.8 million for the year. Earned premiums in 2015 were $156.7 million, as compared with $179.1 million in the previous year. The decline in the earned premiums balance was due mainly to a decline in the net written premiums for the direct property and liability insurance policies issued to Dow, the non-renewal of certain assumed reinsurance contracts, which were underperforming, and a decrease in participation percentage in various other assumed reinsurance contracts. The underwriting results for 2015 produced income of $34.5 million. This was accompanied by net investment income of $70.7 million, which included $35.0 million of net realized capital gains. The Company carried $40.9 million of unrealized capital gains (net of taxes) in a portfolio consisting of $1.4 billion of invested assets. The investment portfolio was split approximately 64% fixed income, 16% equities, 13% other investments and 7% cash and short term investments at year end 2015. Cash flow from operations was $27.3 million, increasing from $11.8 million in 2014, primarily due to an increase of $22.4 million in premiums collected net of reinsurance (see Cash Flow section below). The Company continues to add value for policyholders in the related captive segment of its business which made up approximately 50% of 2015 earned premiums. The unrelated business, making up the remaining balance of 2015 premiums, continues to present opportunities in niche markets in which the Company participates. Dorinco has solidified its position as a niche market for assumed reinsurance, specializing in less volatile lines of business offering predictable and consistent results. The company is well-positioned for the current market cycle. Regional U.S. insurance companies continue to be the Company s targeted clients. Page 6
REINSURANCE PROGRAM Dorinco participates in an intra group reinsurance plan that utilizes the capacity of each company within the group. Sister company Dorintal Reinsurance Limited participates as a reinsurer (all reserve balances are secured). Separate reinsurance arrangements with commercial insurers and reinsurers exist for the coverage provided to the ultimate parent. ORGANIZATIONAL PROCESS The Company utilizes a quantitative pricing model and has taken a hands on management of its reserving practices by its own Actuarial Business Service Unit. This unit interfaces with the independent consulting actuary appointed by the Board of Directors. RISK MANAGEMENT OF CATASTROPHE EXPOSURES Guidelines are established for assumed contracts with catastrophe exposure to include a cap to the limit of liability. Maximum exposure by contract is monitored on a geographic basis. This information is used in establishing underwriting direction and the purchasing of reinsurance. With the reduction in the assumed reinsurance portfolio subject to catastrophe loss, the Company currently relies less on catastrophe modeling of probable maximum loss and more on the monitoring of its exposures on a gross limits exposed basis. ENTERPRISE RISK MANAGEMENT The Company utilizes several models, metrics and evaluation methodologies in effectuating enterprise risk management. Insurance risk management techniques include: underwriting, catastrophe management, and reserve adequacy management. Dorinco looks for non-correlation of Dow and thirdparty risks. Third party risks are U.S.-only exposed, primarily short-tail nonstandard auto risks. Geographic exposure accumulation is described under Risk Management of Catastrophe Exposures. Reserves are established internally by claim, line of business, and/or policy. Reserves are reviewed internally on a quarterly basis and annually by external actuaries. Methodologies used in reserve analysis include: Company loss development, industry loss development, adjusted loss development and Bornheutter Ferguson. Investment risk management includes setting parameters for asset allocation, volatility appetite, and investment policy. These investment measures are monitored by the Finance Committee and presented to the Board of Directors. There is a Board-approved delegation of authority for policy underwriting, based upon business type, premium level, and exposure limits. There is an established delegation of authority for claim payments, with larger payments requiring formal review prior to authorization. Optimization of capital structure is reviewed monthly and maximum policy limits and investment risk are monitored at that time. The Finance Committee and Board of Directors meet quarterly; the management team meets monthly, at a minimum. Dorinco leverages its formal disaster recovery program from its ultimate parent. Page 7
UNDERWRITING RESULTS $MILLION 2015 2014 Underwriting Results: Gross premiums written 310.1 318.1 Net premiums written 153.7 171.7 Net premiums earned 156.7 179.1 Loss and loss adjustment expense ratio 60.1% 70.8% Underwriting expense ratio 16.8% 16.7% Combined ratio 76.9% 87.5% Gross premiums written decreased to $310.1 million in 2015, from $318.1 million in 2014, primarily from the related captive segment of the Company s business as market conditions continued to suppress premium growth. Dorinco s combined ratio as reported in the Annual Statement for 2015 amounted to 76.9%, a decrease from 87.5% in 2014. Dorinco is a part of Dow's consolidated federal income tax return. Dorinco and Dow have entered into a tax allocation agreement whereby Dorinco computes and pays its tax obligation as if separate returns were being filed. CASH FLOW III. CASH FLOW AND LIQUIDITY Primary sources of cash for the Company include cash provided from premiums collected, dividend and interest income, and proceeds from the sale or maturities of invested assets. The cash flows of Dorinco for 2015 and 2014 are summarized below: $MILLION 2015 2014 Cash Provided by Operations 27.3 11.9 Cash From Investment Activities 45.5 71.5 Other Cash Used (46.4) (47.3) Net Increase in Cash and Short-Term Investments 26.4 36.1 Operating cash flow in 2015 was higher than in 2014, primarily due to an increase of $22.4 million in premiums collected net of reinsurance. The increase in premiums collected net of reinsurance reflects a shortening of the Company s payment period for ceded premiums associated with the December insurance policy renewals. The shortening of the Company s payment period was initiated in 2014. The Company s 2014 results were negatively impacted by 2013 s December renewals, which were paid in early 2014, a carryover from the Company s previous payment period policy for ceded premiums. Net cash from investment activities was lower in 2015, reflecting the headwinds experienced in the global markets during 2015, principally in the commodities and emerging markets sectors for equities, and the impact of interest rates to the fixed income market during 2015. Page 8
Other cash used remained steady in 2015, primarily incorporating payments for stockholder s dividends of $45.0 million, as compared to $50.0 million paid in 2014. See also Note 13D to the 2015 Annual Statement. Dorinco made no significant capital expenditures in 2015. LIQUIDITY Dorinco collects and invests premiums written in advance of payments for associated claims. Funds available for investment which exceed the amount required to satisfy liabilities are primarily invested in fixed income, equities and short-term securities. For 2015 and 2014, Dorinco met its cash needs from internally generated funds. Dorinco does not anticipate any difficulties in meeting its future cash needs. Page 9