The Company's administrative offices are occupied pursuant to a lease from an unaffiliated company which expires May 14, 2000 in a building located at 123 William Street, New York, New York. Several of the Company's subsidiaries have noncancellable operating leases for their respective office location. The Company does not own any real estate.
The following table sets forth summary consolidated financial information of the Company for each of the years in the five-year period ended December 31, 1998 derived from the Company's audited consolidated financial statements. See the Consolidated Financial Statements of the Company including notes thereto included herein.
General. The Company's 1998 and 1997 results of operations reflect intense market competition in the marine and aviation lines.
Lloyd's Syndicate 1221 had capacity of $111.1 million in 1998 and $113.1 million in 1997. The Company participated through NCUL and Millennium for an aggregate 39.5% of the 1998 business and through NCUL for 22.8% of the 1997 business produced by MTC for Syndicate 1221. The Lloyd's marine business has been subject to continued pricing competition resulting in less premiums per risk relative to certain prior years. As a result, the Company wrote less than the capacity available.
At December 31, 1998, Syndicate 1221 and an unaffiliated syndicate on which NCUL participated in 1997 closed their 1996 underwriting year resulting in a portfolio transfer to NCUL at December 31, 1998. This transaction accounted for the majority of the increase in the premium volume in the Company's Lloyd's operations from 1997 to 1998 generating $19.7 million as additional written and earned premium and losses incurred in the same amount at December 31, 1998. There was no gain or loss on the transaction. The amount agreed upon to close an underwriting year into the next year is referred to as the "reinsurance to close."
Aviation Premium. Aviation gross written premium decreased 33% from 1997 to 1998 as the result of Navigators Insurance's withdrawal from aviation business effective October 1998, other than a small amount of war and satellite business, due to inadequate pricing in the aviation insurance market. The 15% reduction in aviation gross written premium from 1996 to 1997 was due to decreasing the amount of exposure written per risk and to price competition.
Onshore Energy Premium. In 1996, Navigators Insurance began to underwrite onshore energy business which principally focuses on the oil and gas, chemical and petrochemical, and power generation industries with coverages primarily for property damage and machinery breakdown. In 1999, the Company will primarily write onshore energy business though its facilities at Lloyd's. The UK Branch will participate in the business written through Lloyd's.
CEDED PREMIUM. In the ordinary course of business, the Company reinsures certain insurance risks with unaffiliated insurance companies for the purpose of limiting its maximum loss exposure, protecting against catastrophic losses, and maintaining desired ratios of net premiums written to statutory surplus. The increase in the ceded premium from 1996 to 1997 and from 1997 to 1998 resulted from the engineering and construction business and the program business, which were heavily reinsured, and from increasing the reinsurance on the marine business. In addition, beginning July 1, 1998, Navigators Insurance began writing 100% of the marine risks and then ceded 40% to the pool members.
NET EARNED PREMIUM. The 7.3% increase in net earned premium from 1997 to 1998 and the 8.0% increase in net earned premium from 1996 to 1997 was primarily due to the increase in the net written premium in 1997.
COMMISSION INCOME. Commission income increased 29.2% to $6.6 million in 1998 from $5.1 million in 1997 due to the profit commission earned by MTC from the 1996 underwriting year partially offset by Navigators Insurance increasing its participation in the marine pool to 60% in 1998 from 48% in 1997 which decreased both the management commission and the profit commission. The MTC profit commission was also included as other operating expenses under bonus arrangements with certain of the MTC staff. The commission income decreased 42.2% from 1996 to 1997 due to Navigators Insurance increasing its participation in the marine pool from 41% in 1996 to 48% in 1997. Also, the 1996 commission income includes $826,000 of profit commissions earned under a management agreement with a former affiliate associated with Lloyd's.
Commission Expense. Commission expense as a percentage of net earned premium was 13.0%, 17.6%, and 15.5% for 1998, 1997 and 1996, respectively. The decrease in the 1998 commission expense ratio compared to 1997 was primarily due to the $19.7 million of reinsurance to close premium resulting from
closing of the Lloyd's 1996 underwriting year. The 1998 commission expense ratio without the 1996 reinsurance to close premium was 16.6%. The increase in the 1997 commission expense ratio compared to 1996 was primarily due to increased excess of loss reinsurance purchased in 1997 on the marine, aviation and onshore energy lines of business which lowers net premium with no corresponding ceding commission to offset the commission expense incurred on the gross premium and to a generally higher commission percentage on the Lloyd's premium.
Net Income. The Company's net income decreased in 1998 to $11.5 million from $12.5 million in 1997 and from $16.8 million in 1996 primarily due to price competition and expenses related to the expansion in London and Australia.
The increase in the reinsurance receivable on paid and unpaid losses and loss adjustment expenses, and the increase for reserves for losses and loss adjustment expenses at December 31, 1998 as compared to 1997 was primarily due to energy and engineering claims reported in the fourth quarter which were heavily reinsured, and the Lloyd's "reinsurance to close" loss portfolio for the 1996 underwriting year.
The Company was within the usual values for all NAIC's IRIS ratios as of December 31, 1997 and 1998.
variety of factors, including general economic conditions and conditions in the insurance and reinsurance markets, as well as fluctuations from year to year in claims experience.
The Company is a specialty insurance company and periods of moderate economic recession or inflation tend not to have a significant direct affect on the Company's underwriting operations. They do, however, impact the Company's investment portfolio. A decrease in interest rates will tend to decrease the Company's yield on its invested assets.
Management considers the potential impact of these economic trends in estimating loss reserves. Management believes that the underwriting controls it maintains, and the fact that the majority of the Company's business is in lines of insurance which have relatively short loss payout patterns, assist in estimating ultimate claim costs more accurately and lessen the potential adverse impact of the economy on the Company.
The Company's preparation for Y2K Issues has been ongoing for over two years and continues to proceed. The Company formed a Y2K Executive Committee comprised of senior management in all areas of our operations including financial, underwriting, claims and information technology departments. The Executive Committee has addressed the Y2K Issue from three different perspectives: (1) internal hardware/software compliance; (2) third-party vendor compliance; and (3) the Company's underwriting and claims position.
The Company's overall Y2K plan of action consists of at least five phases. Phase one was an initial awareness stage that involved the identification and inventory of information technology and non-information technology systems that are critical to the operation of the Company. This stage included developing a listing of material business relationships with hardware/software providers and third-party vendors. The Company believes this information gathering stage is now 100% complete. Nevertheless, the Company continues to review this area to determine whether any supplemental information may be necessary.
Phase three consists of the repair and/or replacement of material systems that were determined not to be Y2K compliant. With respect to internal hardware/software compliance, the Company has recently
Phase five calls for the Company to develop contingency plans in the event some aspects of either the internal systems or third-party vendors are adversely effected by a Y2K situation. Since the Company's internal system testing is incomplete and all third-party vendors have not provided Y2K compliance certifications, the contingency plans specific to Y2K are still evolving. However, in the normal course of business, the Company maintains detailed contingency plans designed to protect and secure its business records and data in the event of a business interruption. Also, the Company has back-up procedures that do not rely upon computers. In the event of an interruption due to an outside vendor being non-Y2K compliant, and assuming that the Company's phone and fax lines and mail delivery services are operational, the Company may operate its business without material effect. Much of the Company's day-to-day operation depends upon client contact and claims service. The Company has the ability to issue manual checks to our clients and vendors which will allow the Company to continue normal business operations in the event of a short-term computer shutdown.
Since the Company operates in New York, Houston, Seattle, San Francisco and London, if one office does experience a business interruption, phone and fax communications may be re-routed to the other offices. This will ensure uninterrupted service for our clients. While every possible scenario cannot be anticipated, the Company believes it has instituted contingency measures to adequately address most issues that may arise.
To date, the Company has spent approximately $1.2 million on the replacement of the underwriting, claims and accounting systems that needed to be replaced regardless of the Y2K Issue. Prospectively, the Company estimates the cost of completing testing and potential contingency action to be approximately $300,000. These costs will be expended out of working capital, and the Company believes such prospective costs will not have a material effect on liquidity or financial condition. No information technology projects have been deferred due to the Company's Y2K efforts and expenditures.
The Company is also at risk from its policyholders' claims for insurance coverage due to their Y2K exposures. Although the Company has not received any insurance claims based on losses resulting from Y2K Issues, there can be no assurance that policyholders will not suffer losses of this type and seek compensation under the Company's insurance policies. If any claims are made, the Company's obligations, if any, will depend on the facts and circumstances of the claim and provisions of the policy. At this time, the Company is unable to determine whether an adverse impact, if any, in connection with the foregoing circumstances would be material.
The aforementioned Year 2000 discussion contains forward-looking statements about matters that are inherently difficult to predict with respect to completion of Year 2000 compliance and the effect on the Company. Such statements are made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and involve a number of risks and uncertainties that could materially affect future results.
The carrying value of the Company's investment portfolio as of December 31, 1998 was $254.4 million of which 97.7% was invested in fixed maturity securities. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed maturity securities. The Company's exposure to equity price risk and foreign exchange risk is not significant. The Company has no commodity risk.
Sensitivity analysis is defined as the measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In the Company's sensitivity analysis model, a hypothetical change in market rates is selected that is expected to reflect reasonably possible near-term changes in those rates. The term "near-term" means a period of time going forward up to one year
Based on the sensitivity analysis model used by the Company, the loss in fair value of market sensitive instruments, as a result of a 100 basis point increase in interest rates as of December 1998, is not material.