Our executive and administrative office is located at 6 International Drive in Rye Brook, N.Y. Our lease for this space expires in February 2013. Our underwriting operations are in various locations with non-cancelable operating leases including Chicago, IL, Coral Gables, FL, Corona, CA, Houston, TX, Irvine, CA, North Haven, CT, New York City, NY, San Francisco, CA, Schaumburg, IL, Seattle, WA, Basingstoke, London and Manchester, England and Antwerp, Belgium.
The following table sets forth selected consolidated financial data including consolidated financial information of the Company for each of the years in the five-year period ended December 31, 2006 derived from the Company's audited consolidated financial statements. You should read the table in conjunction with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data, included in this Annual Report on Form 10-K.
We are an international insurance holding company focusing on specialty products for niches within the overall property/casualty insurance market. The Company's underwriting segments consists of insurance company operations and operations at Lloyd's of London. Our largest product line and most long-standing area of specialization is ocean marine insurance. We have also developed specialty niches in professional liability insurance and in specialty liability insurance primarily consisting of contractors' liability and excess liability coverages. We conduct operations through our Insurance Companies and our Lloyd's Operations. The Insurance Companies consist of Navigators Insurance Company, which includes a United Kingdom Branch, and Navigators Specialty Insurance Company, which underwrites specialty and professional liability insurance on an excess and surplus lines basis fully reinsured by Navigators Insurance Company. Our Lloyd's Operations include NUAL, a Lloyd's underwriting agency which manages Syndicate 1221. We participate in the capacity of Syndicate 1221 through two wholly-owned Lloyd's corporate members.
While management takes into consideration a wide range of factors in planning the Company's business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how the Company is managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Management's assessment of our trends and potential growth in underwriting profit is the dominant factor in its decisions with respect to whether or not to expand a business line, enter into a new niche, product or territory or, conversely, to contract capacity in any business line. In addition, management focuses on managing the costs of our operations. Management believes that careful monitoring of the costs of existing operations and assessment of costs of potential growth opportunities are important to our profitability. Access to capital also has a significant impact on management's outlook for our operations. The Insurance Companies' operations and ability to grow their business and take advantage of market opportunities are particularly constrained by regulatory capital requirements and rating agency assessments of capital adequacy. For example, we contributed $100 million of the approximately $123.5 million in net proceeds we received from our April 2006 public debt offering and we contributed $120 million of the approximately $123.8 million in net proceeds we received from our October 2005 equity offering to the statutory surplus of Navigators Insurance Company in order to position the Company to be able to capitalize on domestic and international insurance business opportunities that management believes will be profitable.
Our revenue is primarily comprised of premiums and investment income. The Insurance Companies derive their premiums primarily from business written by the Navigators Agencies, which are wholly-owned insurance underwriting agencies of the Company. The Lloyd's Operations derive their premiums from business written by NUAL. Beginning in 2006, the Navigators Agencies produce and manage business only for the Insurance Companies and are reimbursed for actual costs. Prior to 2006, the Navigators Agencies received commissions and, in some cases, profit commissions on the business produced on behalf of the Insurance Companies and other unaffiliated insurers. NUAL is reimbursed for its actual costs and, where applicable, profit commissions on the business produced for Syndicate 1221.
Over the past three to four years, we have experienced generally beneficial market changes in our lines of business. As a result of several large industry losses in the second quarter of 2001, the marine insurance market began to experience diminished capacity and rate increases, initially in the offshore energy line of business. The marine rate increases began to level off in 2004 and into 2005. As a result of the substantial insurance industry losses resulting from Hurricanes Katrina and Rita, the marine insurance market experienced diminished capacity and rate increases, particularly for the offshore energy risks located in the Gulf of Mexico. The 2006 year average renewal rate increases for all marine lines of business, including offshore energy, was approximately 11% in the Insurance Companies and 13% in the Lloyd's Operations. Included in the marine rate increases for the 12 months of 2006 are offshore energy rate increases of approximately 54% in the Insurance Companies and 57% in the Lloyd's Operations. We expect overall moderate declines in 2007 pricing for marine lines of business, including offshore energy, as additional capacity re-enters the marine market.
Specialty liability losses in 2001 to 2003, particularly for our construction liability business, also resulted in diminished capacity in the market in which we compete, as many former competitors who lacked the expertise to selectively underwrite this business have been forced to withdraw from the market resulting in approximate rate increases of 13% in 2004 and 49% in 2003. This was followed by a slight decline in rates of approximately 1% in 2005. The 2006 year average renewal rates for the construction liability business declined approximately 6%, primarily due to additional competition in the marketplace. We expect competitive conditions will continue into 2007 resulting in continued moderate declines in pricing for construction liability and excess liability business.
In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with financial and accounting scandals at publicly traded corporations and the increased frequency of securities-related class action litigation, has led to heightened interest in professional liability insurance generally. Average professional liability renewal premium rates were relatively level in both the 2006 and 2005 years after decreasing approximately 3% in 2004 which followed substantial rate increases in 2003 and 2002, particularly for D&O insurance. The D&O insurance premium rates decreased approximately 2%
for the 2006 year, after decreases of approximately 2% in 2005 and 10% in 2004. We anticipate continuing moderate declines in 2007 pricing given the overall favorable industry underwriting results since 2002 for the professional liability lines of business.
Our Insurance Companies and Lloyd's Operations have exposure to losses caused by hurricanes and other natural and man-made catastrophic events. The frequency and severity of catastrophes are unpredictable.
The Company has significant catastrophe exposures throughout the world with the largest catastrophe exposure for offshore energy risks due to hurricanes in the Gulf of Mexico. The Company believes that its estimated probable maximum pre-tax gross and net loss exposure in a one in two hundred and fifty year hurricane event in the Gulf of Mexico would approximate $168 million and $32 million, respectively, including the cost of reinsurance reinstatement premiums. There are a number of significant assumptions and related variables related to such an estimate including the size, force and path of the hurricane, the various types of the insured risks exposed to the event at the time the event occurs and the estimated costs or damages incurred for each insured risk. There can be no assurances that the gross and net loss amounts that the Company could incur in such an event or in any hurricanes that may occur in the Gulf of Mexico would not be materially higher than the estimates discussed above given the significant uncertainties with respect to such an estimate.
The occurrence of large catastrophic loss events could reduce the reinsurance coverage that is available to us and could weaken the financial condition of our reinsurers, which could have a material adverse effect on our results of operations. Although the reinsurance agreements make the reinsurers liable to us to the extent the risk is transferred or ceded to the reinsurer, ceded reinsurance arrangements do not eliminate our obligation to pay claims to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. Specifically, our reinsurers may not pay claims made by us on a timely basis, or they may not pay some or all of these claims. Either of these events would increase our costs and could have a material adverse effect on our business. We are required to pay the losses even if a reinsurer fails to meet its obligations under the reinsurance agreement.
Hurricanes Katrina and Rita (the "2005 Hurricanes") which occurred in the 2005 third quarter generated substantial losses to the property and casualty industry and the marine and energy insurance market due principally to offshore energy losses. Hurricane Wilma, which occurred in the 2005 fourth quarter, also generated substantial losses to the property and casualty industry but was not significant to either the marine and energy line of business or to the Company in general, in comparison to Hurricanes Katrina and Rita. There were no significant hurricane losses in 2006 that impacted the marine and energy lines of business of the Company.
The impact of the 2005 Hurricanes on our 2005 financial results follow:
Approximately 25% of the gross losses incurred for the 2005 Hurricanes were generated by our Lloyd's Operations from assumed excess of loss marine reinsurance, a substantial portion of which was retroceded. A large portion of this assumed reinsurance was not renewed in 2006.
To the extent a hurricane similar in force and following similar paths of Hurricane Katrina or Rita were to occur in 2007, the Company's gross losses would be substantially less than in 2005 given the reductions in coverages provided by the Company in the Gulf of Mexico but the net loss would be substantially greater given the reduced availability of excess of loss reinsurance protection for such exposures coupled with the increased cost of excess of loss reinstatement premiums.
It is important to understand our accounting policies in order to understand our financial statements. Management considers certain of these policies to be critical to the presentation of the financial results, since they require management to
make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures at the financial reporting date and throughout the reporting period. Certain of the estimates result from judgments that can be subjective and complex and, consequently, actual results may differ from these estimates, which would be reflected in future periods.
Reinsurance Recoverables. Reinsurance recoverables are established for the portion of the loss reserves that are ceded to reinsurers. Reinsurance recoverables are determined based upon the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Additional information regarding our reinsurance recoverables can be found in the "Description of Business-Reinsurance Ceded" section and Note 6 to our consolidated audited financial statements, both included herein.
Written and Unearned Premium. Written premium is recorded based on the insurance policies that have been reported to us and the policies that have been written by agents but not yet reported to us. We must estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results. An unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date. Additional information regarding our written and unearned premium can be found in Notes 1 and 6 to our consolidated audited financial statements, both included herein.
A portion of the Company's premium is estimated for unreported premium, mostly for the marine business written by our U.K. Branch and Lloyd's Operations. We generally do not experience any significant backlog in processing premiums. Of the
Deferred Tax Assets. We apply the asset and liability method of accounting for income taxes whereby deferred assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. Additional information regarding our deferred tax assets can be found in Notes 1 and 7 to our consolidated audited financial statements, both included herein.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security's unrealized loss represents an other-than- temporary decline. The Company's ability to hold such securities is supported by sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment and other disbursement obligations arising from its underwriting operations without selling such investments. With respect to securities where the decline in value is determined to be temporary and the security's value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, market conditions and assessing value relative to other comparable securities. Management of the Company's investment portfolio is outsourced to third party investment managers. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company's portfolio as available for sale.
Investment managers are required to notify management of rating agency downgrades of securities in their portfolios as well as any potential investment valuation issues at the end of each quarter. Investment managers are also required to notify management to the extent the investment manager is contemplating a transaction or transactions that may result in a realized
loss above a certain threshold. Additionally, investment managers are required to notify management if they are contemplating a transaction or transactions that may result in any realized loss up until a certain period beyond the close of a quarterly accounting period.
Translation of Foreign Currencies. Financial statements of subsidiaries expressed in foreign currencies are translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation, issued by the Financial Accounting Standards Board ("FASB"). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using period end rates of exchange and the related translation adjustments are recorded as a separate component of accumulated other comprehensive income. Statement of income amounts expressed in functional currencies are translated using average exchange rates.
Gains and losses resulting from foreign currency transactions are recorded in other income (expense) in the Company's Consolidated Statements of Income.
Consolidated stockholders' equity increased 17% to $551.3 million or $32.94 per share at December 31, 2006 compared to $470.2 million or $28.30 per share at December 31, 2005. The increase was primarily due to 2006 net income of $72.6 million.
Cash flow from operations was $146.0 million, $247.8 million and $158.5 million in 2006, 2005 and 2004, respectively, contributing to the growth in invested assets and net investment income. Investment income increased 53.5% in 2006 to $56.9 million compared to 2005 and increased 38.4% in 2005 to $37.1 million compared to 2004 as the result of both the increase in invested assets and the increase in investment yields. The 2006 cash flow from operations was reduced by gross loss payments of approximately $146.5 million for losses from the 2005 Hurricanes and $19.9 million for settled asbestos claims less reinsurance recoveries of approximately $70.5 million and $3.7 million, respectively. Reinsurance recoverables of $66.6 million and $7.7 million for such 2006 gross loss payments for losses from the 2005 Hurricanes and settled asbestos claims, respectively, are due to be collected from reinsurers in subsequent accounting periods.
The 2006 results of operations continue to reflect improved financial performance compared to 2005 (excluding the 2005 Hurricanes) and 2004 due to a combination of improved underwriting results and the growth in net investment income.
The 2005 results of operations reflect improved financial performance consistent with the 2004 year excluding hurricane losses. The 2005 results of operations were adversely impacted by an after-tax charge of $23.9 million or $1.75 per share from the losses resulting from Hurricanes Katrina and Rita. The Company's combined ratio of 101.3% was negatively impacted by 10.5 points from Hurricanes Katrina and Rita while being reduced by 1.1 loss ratio points from a net redundancy of prior years' loss reserves of $3.8 million.
During October 2005, the Company enhanced its financial position and ability to take advantage of market opportunities for its insurance operations by contributing $120.0 million of the $123.8 million of the net proceeds from its equity offering to the statutory surplus of the Insurance Companies.
The 2004 underwriting results benefited from the improved market conditions as reflected in increased premium rates coupled with the recording of a net redundancy of prior years' loss reserves of $3.8 million which reduced the 2004 combined ratio of 92.2% by 1.2 loss ratio points.
While pre-tax investment yields declined to 3.5% in 2004 compared to 3.8% in 2003, net investment income increased 37% due to the cash flow from operations coupled with the net proceeds of the Company's October 2003 equity offering.
Revenues. Gross written premium increased to $970.8 million in 2006 from $779.6 million in 2005 and from $696.1 million in 2004, increases of 25%, 12% and 14.8% in 2006, 2005 and 2004, respectively. The growth in gross premiums over the three year period reflects a combination of business expansion in both new and existing lines of business coupled with premium rate changes on renewal policies. The premium rate increases or decreases as noted below for marine, specialty and professional liability are calculated primarily by comparing premium amounts on policies that have renewed. The premiums are judgmentally adjusted for exposure factors when deemed significant and sometimes represent an aggregation of several lines of business. The rate change calculations provide an indicated pricing trend and are not meant to be a precise analysis of the numerous factors that affect premium rates or the adequacy of such rates to cover all underwriting costs and generate an underwriting profit. The calculation can also be affected quarter by quarter depending on the particular policies and the number of policies that renew during that period. Due to market conditions, these rate changes may or may not apply to new business which may be more competitively priced compared to renewal business. The following table sets forth our gross and net written premium and net earned premium by segment and line of business for the periods indicated:
Marine Premium. The gross written premium for 2006 consisted of 32% marine liability, 20% offshore energy, 10% transport, 10% cargo and 9% protection & indemnity, with the remainder in other marine related classes of business.
The marine gross written premium for 2006 increased 14.0% compared to 2005 due to growth across several lines of business including offshore energy which benefited from rate increases following losses from the 2005 Hurricanes and protection & indemnity where growth was driven by new business. The average marine renewal premium rates during 2006 increased approximately 11%, including the approximate 54% increase in offshore energy rates which was primarily the result of the 2005 Hurricane losses. We expect overall moderate declines in 2007 pricing for marine business including offshore energy lines of business as additional capacity re-enters the marine market. The 2005 marine gross written premium increased 11.1% principally due to growth across several lines of business including cargo, offshore energy and liability. The rate increases in the marine business averaged approximately 1.5% in 2005. During 2005, we also began to insure customs bonds. Navigators Insurance Company obtains its marine business through participation in the marine pool managed by the Navigators Agencies. Its participation in the marine pool was 85% in 2005 and 80% in 2004. Commencing in 2006, the marine pool was eliminated and, therefore, all of the marine business generated by the Navigators Agencies was exclusively for Navigators Insurance Company.
Specialty Premium. The gross written premium for 2006 consisted of 51% general liability business for small general and artisan contractors, 17% excess casualty business, 12% commercial middle markets business, 11% personal umbrella business, 7% primary casualty business and the remainder in other targeted commercial risks.
The 2006 gross written premium increased 47.9% when compared to 2005 reflecting growth across all lines of business and premiums generated from our primary casualty business, which started in the third quarter of 2006. During 2005 we launched our excess casualty division in the first quarter and expanded our presence in the hospitality business by writing general liability insurance which includes liquor law liability coverage for commercial establishments such as bars, restaurants and night clubs contained in our middle markets unit. We also commenced writing first party personal lines warranty coverage on underground fuel tanks excluding pollution coverage. The average renewal rate changes in the contractors' liability business decreased approximately 6% and 1% in 2006 and 2005, respectively, following increases of 13% and 49% in 2004 and 2003, respectively. The recent premium rate decreases were reflective of softening market conditions which are expected to continue into 2007.
Professional Liability Premium. The gross written premium for 2006 consisted of 68% D&O insurance for privately held and publicly traded corporations, 24% professional liability coverage for lawyers and other professionals and 8% professional liability coverage for architects and engineers. In 2002, the professional liability business was expanded to include errors and omissions insurance and employment practices liability coverages. Commencing in October 2004, our U.K. Branch began writing professional liability coverages for U.K. solicitors and, in 2005 we began writing professional liability coverages for architects and engineers. The professional liability premium increased 6.7% to $92.8 million in 2006 from $86.9 million and 22.4% in 2005 compared to $71.0 million in 2004 reflecting growth and the expansion of this business for all lines. Approximately $6.6 million of international professional liability business written by the insurance companies in 2005 has been renewed in the Lloyd's Operations in 2006. Average overall renewal premium rates for this business were relatively level in 2006 and 2005 after decreasing approximately 3.2% in 2004 compared to increases of approximately 28% in 2003. D&O rates decreased approximately 2% in 2006, 2.3% in 2005 and 9.5% in 2004. These premium rate decreases were reflective of softening market conditions which are expected to continue into 2007.
Other Premiums. Other premiums include gross written premium assumed from our Syndicate 1221 through quota share treaties consisting of marine and energy business of ($1.5) million in 2005 and $26.0 million in 2004. In 2005, the negative premium represents the reversal of prior year premium accruals. The 2004 gross written premium includes $22.2 million of gross and net written and earned premium, representing Navigators Insurance Company's share of reinsurance to close premiums recorded by Syndicate 1221 as a result of the transfer of assets and liabilities from the participants of the 2002 underwriting year to the 2003 underwriting year of Syndicate 1221. The RITC had no effect on the 2006 or 2005 gross written premium.
The generally improved pricing environment since 2002 resulted in Syndicate 1221 increasing its stamp capacity in 2004 to take advantage of favorable market conditions as reflected in higher average renewal premium rates averaging 0.6% in 2004 and 15% in 2003. The stamp capacities for 2006 and 2005 were reduced in anticipation of less favorable market conditions in 2006 and 2005 and reflecting unused stamp capacity in 2004. The 2007 stamp capacity has been increased to £140 million ($273 million), reflecting modest growth in marine business and business expansion in new lines of business such as international professional liability and property business.
Professional Liability Premium. Syndicate 1221 commenced writing international D&O business during the second quarter of 2005 and produced $21.8 million and $6.6 million of international D&O gross written premium in 2006 and 2005, respectively.
Ceded Written Premium. In the ordinary course of business, we reinsure certain insurance risks with unaffiliated insurance companies for the purpose of limiting our maximum loss exposure, protecting against catastrophic losses, and maintaining desired ratios of net premiums written to statutory surplus. The relationship of ceded to written premium varies based upon the types of business written and whether the business is written by the Insurance Companies or our Lloyd's Operations.
The ratio of total ceded written premium to total gross written premium in 2006 was 46.4% compared to 51.2% for 2005 and 55.1% for 2004. The Insurance Companies' marine and Lloyd's Operations 2005 ceded written premium includes $14.4 million of reinstatement premium related to the losses from the 2005 Hurricanes. The Insurance Companies' marine and Lloyd's Operations 2004 ceded written premium includes $1.5 million and $0.8 million, respectively, of reinstatement premium related to the losses from Hurricane Ivan.
due to the reductions in ceded reinsurance premiums discussed above and 26.3% when the effects for ceded reinstatement premiums as a result of the 2005 Hurricanes are excluded.
Net Earned Premium. Net earned premium increased 38.3% in 2006 compared to 2005 and increased 8.9% in 2005 compared to 2004. The 2006 net earned premium reflects the strong growth in written premiums and the effect of ceded reinstatement premiums resulting from storm losses that affected 2005. The 2005 net earned premium was reduced by $14.5 million of reinstatement premium as a result of the losses from the 2005 Hurricanes. Excluding the effects for ceded reinstatement premiums as a result of the 2005 Hurricanes, net earned premium increased 32.7% in 2006 compared to 2005 and increased 13.5% in 2005 compared to 2004. The 2005 and 2004 net earned premium include $2.5 million and $12.8 million, respectively, as a result of the RITC transactions.
Commission Income. Commission income from unaffiliated business decreased 45.9% to $3.1 million in 2006 compared to $5.7 million in 2005 and $4.8 million in 2004. The 2006 amount reflects the elimination of the marine pool. The 2005 increase principally resulted from higher profit commission in the Lloyd's Operations on the closing of the 2003 year of account. Commission income from the Navigators Agencies decreased as the result of less profit commission due to the losses generated by Hurricanes Katrina and Rita and the increase in Navigators Insurance Company's participation in the marine pool to 85% in 2005 from 80% in 2004. Beginning with the 2006 underwriting year, there are no longer any marine pool unaffiliated insurance companies with the elimination of the marine pool and no longer any unaffiliated participants at Syndicate 1221 with the purchase of the minority interest. Any profit commission would therefore result from the run-off of underwriting years prior to 2006.
Other Income/(Expense). Other income/(expense) for 2006, 2005 and 2004 consisted principally of both foreign exchange gains and (losses) of ($1.8) million, $1.7 million and ($1.3) million, respectively, primarily related to the Lloyd's Operations, and of inspection fee income of $0.9 million, $1.0 million and $0.9 million, respectively, related to the specialty insurance business.
The following table sets forth our net loss and LAE reserves by segment and line of insurance business and the total case reserves and IBNR as of the date indicated:
At December, 2006, the IBNR loss reserve was $452.9 million or 65.1% of our total loss reserves compared to 60.5% in 2005 and 59.1% in 2004.
The increase in gross incurred losses on the Company's 2006 and 2005 balance sheets primarily relates to incurred losses for events occurring in those years less loss payments. Approximately 79% of the 2005 increase in the gross loss reserves and 94% of the 2005 increase in reinsurance recoverables relate to losses from the 2005 Hurricanes. Gross loss reserves and related
IBNR loss reserves are calculated by the Company's actuaries using several standard actuarial methodologies, including the paid and incurred loss development and the paid and incurred BornheutterFerguson loss methods. Additional analyses, such as frequency/severity analyses, are performed for certain books of business.
While we have a significant amount of loss development data that is utilized by our actuaries to establish the IBNR loss reserves for our contractors liability business, there have been significant changes relating to this product and its market that could affect the applicability of our data. For example, one factor that may affect reserves and claim frequency is legislation implemented in California, which generally provides consumers who experience construction defects a method other than
The Insurance Companies recorded $6.1 million of net prior years' savings for specialty business of which $18.6 million was for favorable loss trends for construction liability business written in 2005 and 2004 offset by net prior years' reserve deficiencies of $12.5 million principally for business written from 2003 to 2000 which was mostly for construction defect claims emergence in those years.
As discussed above, the Company establishes reserves for the professional liability business using ultimate loss ratios based on industry experience. During 2005, the Insurance Companies further reduced the reserves for such claims-made policies compared to year-end 2004, by approximately $3 million mostly all related to the 2003 and 2002 underwriting years. The reductions were to recognize the low level of claim counts and continued favorable development compared to expectations at the time the reserves were initially established.
The Insurance Companies recorded $0.8 million of net prior years' savings for run-off business principally due to favorable loss experience on aviation business discontinued in 1999.
The Insurance Companies recorded net prior years' reserve deficiencies of $900,000 for specialty business due to a limited amount of adverse development for a line of business discontinued in 2005 and construction business offset by favorable development in specialty business written in the mid-west.
Following is a discussion of relevant factors impacting our 2004 loss reserves.
$6.6 million net prior years' savings recorded by our Lloyd's Operations and the $2.2 million net prior years' savings recorded by our Insurance Companies for the business assumed from Lloyd's.
In addition, we must consider the uncertain effects of industry-wide emerging or potential claims and coverage issues. These issues could have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims. Recent examples of emerging or potential industry-wide claims and coverage issues include increases in the number and size of directors and officers liability and errors and omissions liability claims arising out of investment banking practices and accounting and other corporate malfeasance up until 2005, which then declined in 2006, and increases in the number and size of water damage claims related to remediation of mold conditions. As a result of issues such as these, it has become increasingly difficult to estimate ultimate claim costs on the basis of past experience, further complicating the already complex loss reserving process.
The future impact of the various factors described above that contribute to the uncertainty in the loss reserving process and of emerging or potential claims and coverage issues is extremely hard to predict and generally cannot be reliably quantified.
The Company records as gross reserves the amount of losses to which it reasonably expects to have exposure and as net reserves that amount less what it reasonably expects to recover in reinsurance. We review the loss reserves for each line of business we write as part of our overall analysis of loss reserves, taking into consideration the variety of trends that impact the ultimate settlement of claims in each particular line of business. The following sensitivity analysis with respect to possible significant variances from the Company's expectations for net loss reserves, identifies and discusses the impact of changes in significant assumptions utilized to establish the Company's loss reserves:
Commission Expense. Commission expense paid to unaffiliated brokers and agents is generally based on a percentage of the gross written premium and is reduced by ceding commissions the Company may receive on the ceded written premium. Commissions are generally deferred and recorded as deferred policy acquisition costs to the extent that they relate to unearned premium. Commission expense as a percentage of net earned premium was 12.4% in 2006, 12.6% in 2005 and 12.6% in 2004. The 2005 percentage excluding the effects of the 2005 Hurricanes was 12.0%.
Other Operating Expenses. The 17.2% and 14.7% increases in other operating expenses when comparing 2006 to 2005 and comparing 2005 to 2004, respectively, are attributable primarily to employee related expenses resulting from expansion of the business.
Income Taxes. The income tax expense was $34.1 million, $10.2 million and $17.2 million for 2006, 2005 and 2004, respectively. The effective tax rates for 2006, 2005 and 2004 were 31.9%, 30.2% and 33.1%, respectively. The Company's effective tax rate is less than 35% due to permanent differences between book and tax return income, with the most significant item being tax exempt interest. As of December 31, 2006 and 2005, the net deferred Federal, foreign, state and local tax assets were $30.4 million and $28.3 million, respectively.
undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the foreign subsidiary assuming all foreign tax credits are realized.
The Company had net state and local operating loss carryforwards amounting to potential future tax benefits of $5,990,000 and $5,009,000 at December 31, 2006 and 2005, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. The Company's state and local tax carryforwards at December 31, 2006 expire from 2021 to 2026.
In July 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), an interpretation of FASB Statement No. 109. FIN 48, which becomes effective in 2007, establishes the threshold for recognizing the benefits of tax-return positions in the financial statements as more-likely-than-not to be sustained by the taxing authorities, and prescribes a measurement methodology for those positions meeting the recognition threshold. The Company does not expect the adoption of FIN 48 to have a material effect on its financial condition or results of operation.
Following are the financial results of the Company's two underwriting segments.
(1)Includes $39.7 million of Assumed from Lloyd's Operations business resulting in a combined ratio of 90.2%. NM = not meaningful
The pre-tax net loss to the Insurance Companies as the result of losses caused by Hurricanes Katrina and Rita of approximately $16.6 million, including $9.1 million of reinstatement costs, increased the Insurance Companies 2005 combined ratio by 6.9 ratio points as follows:
The approximate annualized pre-tax yields on the Insurance Companies' investment portfolio approximated 4.6%, 4.3% and 4.0% for 2006, 2005 and 2004, respectively. The increase in the 2006 yield compared to 2005 was primarily due to the investment of new funds from cash flow and the $100 million statutory surplus contribution from the net proceeds of our April debt offering, in an environment of gradually increasing interest rates. The increase in the 2005 yield compared to 2004 was primarily due to the investment of new funds from cash flow and the $120 million statutory surplus contribution from the net proceeds of our October 2005 equity offering, in an environment of gradually increasing interest rates as monetary policy tightened throughout the year.
Lloyd's presents its results on an underwriting year basis, generally closing each underwriting year after three years. We make estimates for each underwriting year and timely accrue the expected results. Our Lloyd's Operations included in the consolidated financial statements represent our participation in Syndicate 1221.
We provide letters of credit to Lloyd's to support our participation in Syndicate 1221's stamp capacity as discussed below under the caption Liquidity and Capital Resources.
Whenever a member of Lloyd's is unable to pay its debts to policyholders, such debts may be payable by the Lloyd's Central Fund. If Lloyd's determines that the Central Fund needs to be increased, it has the power to assess premium levies on current Lloyd's members up to 3% of a member's underwriting capacity in any one year. The Company does not believe that any assessment is likely in the foreseeable future and has not provided any allowance for such an assessment. However, based on the
(1)Includes other operating expenses and commission income and other income (expense). The Lloyd's Operations have been experiencing business expansion coupled with improving underwriting results as a result of the generally favorable market conditions for marine and energy business from late 2001 through 2003, and continuing to a lesser extent in 2004. Premium rate increases occurred in 2005 and continued into 2006 following Hurricanes Katrina and Rita, particularly in the offshore energy business.
A summary of the effect of the 2004 RITC transaction on our financial statements is as follows:
The net loss to the Lloyd's Operations from Hurricane Ivan of approximately $2.0 million increased the Lloyd's Operations 2004 combined ratio by 2.3 ratio points. The 2004 loss ratio was favorably impacted by $6.7 million or 8.1 loss ratio points for redundancies in prior years' loss reserves.
The pre-tax yields on the Lloyd's Operations' investments approximated 3.4%, 2.4% and 1.7% for 2006, 2005 and 2004, respectively. Generally, the Lloyd's Operations' investments have been invested with a relatively short average duration, which is reflected in the yield, in order to meet liquidity needs. The increase in the Lloyd's Operations 2006 yield compared to 2005 is reflective of the current yield environment driven somewhat by the 2006 increases made to the Federal Funds Rate by the Federal Reserve. The increase in the Lloyd's Operations' 2005 yield compared to 2004 is reflective of the gradual increase in interest rates during 2005. Lloyd's average duration was 1.0 years at December 31, 2006 compared to 1.3 years at December 31, 2005. Such yields are net of interest credits to certain reinsurers for funds withheld by our Lloyd's Operations.
In 2006, 2005 and 2004, the Lloyd's Operations was taxed at a 35% rate as previously discussed under "Results of Operations and Overview-Income Taxes".
(1)Participation after reinsurance of the Lloyd's Operations' corporate capital vehicles, but before other third party reinsurance. For 2007, Syndicate 1221's stamp capacity was increased to £140 million ($274 million) and our participation is 100%, with a reinsurer participation of 5%.
The following table sets forth our known contractual obligations with respect to the items indicated at December 31, 2006:
For a discussion of our investments, see "Description of Business-Investments" included herein.
Cash flow provided by operations was $146.0 million, $247.8 million and $158.5 million for 2006, 2005, and 2004, respectively. The 2006 cash flow from operations was reduced by gross loss payments of approximately $146.5 million for losses from the 2005 Hurricanes and $19.9 million for settled asbestos claims less reinsurance recoveries of approximately $70.5 million and $3.7 million, respectively. Reinsurance recoverables of $66.6 million and $7.7 million for such 2006 gross loss payments for losses from the 2005 Hurricanes and settled asbestos claims, respectively, are due to be collected from reinsurers in subsequent accounting periods. Operating cash flow was used primarily to acquire additional investments of fixed income securities. Beginning in 2006, the Company made certain adjustments to the Consolidated Statements of Cash Flows ("Cash Flow Statements") to identify the impact of foreign exchange rate changes on each section of the Cash Flow Statement. The Cash Flow Statements for 2005 and prior periods have been restated to reflect this change. See Note 1 of Notes to Consolidated Financial Statements for additional information.
At December 31, 2006, the weighted average rating of our fixed maturity investments was "AA" by Standard & Poor's and "Aa" by Moody's. We believe that we have limited exposure to credit risk since the fixed maturity investment portfolio consists of investment-grade bonds. At December 31, 2006, our portfolio had an average maturity of 5.2 years and a duration of 3.9 years. Management continually monitors the composition and cash flow of the investment portfolio in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. No impairment losses were incurred in 2006, 2005 or 2004.
The credit facility is collateralized by all of the common stock of Navigators Insurance Company. The credit agreement contains covenants common to transactions of this type, including restrictions on indebtedness and liens, limitations on dividends, stock buy backs, mergers and the sale of assets, maintaining certain consolidated tangible net worth, statutory surplus and other financial ratios. No dividends have been declared or paid through December 31, 2006. At December 31, 2006, we were in compliance with all covenants.
Time lags do occur in the normal course of business between the time gross losses are paid by the Company and the time such gross losses are billed and collected from reinsurers. During 2006, 2005 and 2004, approximately 46%, 73% and 58%, respectively, of gross incurred losses of approximately $498 million, $886 million and $453 million, respectively, were ceded to reinsurers. Such recoverable amounts are anticipated to be billed and collected over the next several years as gross losses are paid by the Company.
Generally, for pro rata or quota share reinsurance treaties, including pool participants, the Company issues quarterly settlement statements for premiums less commissions and paid loss activity, which are expected to be settled by the end of the subsequent quarter. The Company has the ability to issue "cash calls" requiring such reinsurers to pay losses whenever paid loss activity for a claim ceded to a particular reinsurance treaty exceeds a predetermined amount (generally not more than $1 million) as set forth in the quota share treaty. For the Insurance Companies, cash calls must generally be paid within 30 calendar days. There is generally no specific settlement period for the Lloyd's Operations cash call provisions, but such billings are usually paid within 45 calendar days.
Generally, for excess of loss reinsurers the Company pays monthly or quarterly deposit premiums based on the estimated subject premiums over the contract period (usually one year) which are subsequently adjusted based on actual premiums determined after the expiration of the applicable reinsurance treaty. Paid losses subject to excess of loss recoveries are generally billed as they occur and are usually settled by reinsurers within 30 calendar days for the Insurance Companies and 30 business days for the Lloyd's Operations.
At December 31, 2006, ceded asbestos paid and unpaid losses recoverable were $23.5 million of which $13.1 million and $1.6 million were due from Equitas and Ace International, respectively. In November 2006, the Company filed arbitration
demands against Equitas and Ace International for paid losses recoverable on settled asbestos claims. The approximate ceded paid and unpaid recoverable amounts relating to such arbitrations are $2.7 million for Equitas and $1.6 million for Ace International. For a discussion of our arbitration demands, see Item 3 "Legal Proceedings". The Company generally experiences significant collection delays for a large portion of reinsurance recoverable amounts for asbestos losses given that certain reinsurers are in run-off or otherwise no longer active in the reinsurance business. Such circumstances are considered in the Company's ongoing assessment of such reinsurance recoverables.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our Insurance Companies which could place the Company at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our Insurance Companies or Lloyd's Operations are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of the credit facility.
At December 31, 2006 approximately $4.2 million of investments were held in a tax escrow account on behalf of Navigators Insurance Company until the two-year tax loss carryback periods expire.