The Company is a holding company with ten active wholly owned subsidiaries.
The Somerset Companies specialize principally in four lines of business: marine, aviation and property (primarily inland marine) insurance and certain lines of specialty reinsurance and non-marine insurance. In 1995 they underwrote this business through three syndicates of insurance companies, Navigators having the largest participation in each of the three syndicates. They derive their revenue from commissions, investment income, service fees and cost reimbursement arrangements from Navigators and other insurers. Commissions are earned both on a fixed percentage of premiums and on underwriting profits on business placed with the participating insurance companies within the three syndicates. Property and casualty insurance premiums are cyclical in nature and, accordingly, during a "hard market" demand for property and casualty insurance exceeds supply, or capacity, and as a result, premiums and commissions may increase. On the downturn of the property and casualty cycle, supply exceeds demand, and as a result, premiums and commissions may decrease.
As a result of this loss, management restructured the Company by withdrawing from the large commercial and industrial property business which produced most of the earthquake loss, emphasizing its core ocean marine and aviation business, and developing its inland marine business as well as a new non-marine program book of business.
The results of 1995 reflect this restructuring in that written premiums have been reduced while the continuing book of business has produced profits.
However, the 1995 results also reflect the further development of losses from the Northridge Earthquake. During 1995 the total gross losses on direct property claims arising from the Northridge Earthquake increased approximately $18,340,000 from $125,361,000 to $143,701,000. The Company added gross bulk reserves of $11,000,000 at September 30, 1995, which are expected to cover any further deterioration of losses from the Northridge Earthquake. On a net basis the losses and reserve increase relating to the Northridge Earthquake represent pre-tax charges of approximately $10,721,000 in 1995. There can be no assurance given that additional losses will not be reported or adjustments made to existing reserves.
Revenues. Gross written premium went from $213.7 million in 1993 to $189.6 million in 1994 and to $148.9 million in 1995. The following table sets forth the Company's gross written premium by line of business and net written premium in the aggregate for the periods indicated:
As the above table indicates, since 1993 the composition of the Company's book of business has changed significantly. The marine business has increased from 33% to 42% reflecting the Company's commitment to this core business. Property and inland marine has decreased significantly from 34% to 8% reflecting the withdrawal from property catastrophe business. Aviation has increased from 21% to 34% due in large part to Navigators' increased participation in that line of business. Reinsurance and non-marine program business has increased slightly from 12% to 16%.
Aviation Premiums. Navigators' aviation gross written premium increased 9% from 1993 to 1994 and a further 6% from 1994 to 1995 reflecting the rate increases during this period. Airline premium rates have now stabilized and management does not anticipate growth in aviation premium for 1996.
Property and Inland Marine Premium. Navigators' gross property premium and inland marine decreased 37% from 1993 to 1994 and decreased 75% from 1994 to 1995. In 1994, this business consisted primarily of large commercial and industrial property risks, which was essentially a property catastrophe book of business, with a relatively small amount of inland marine risks. In late 1994, Navigators decided to cease writing large commercial and industrial property risks and to concentrate on inland marine risks and, therefore, 1995 gross written premium is primarily inland marine. Management anticipates growth in this line for 1996 reflecting the emphasis now being placed on this business.
Commission Income. Commission income decreased 2% to $10.7 million during 1995 from $10.9 million and increased 9.8% during 1994. The 1994 increase was due to increased profit commissions from the marine business. The 1995 decrease reflects the withdrawal from the property catastrophe business.
Expenses. The ratio of loss and loss adjustment expenses incurred to net premiums earned ("GAAP loss ratio") was 69.5%, 108.6% and 68.7% in 1995, 1994 and 1993, respectively. The 1994 loss ratio includes direct property losses from the Northridge Earthquake which at that time totalled $35,388,000. The decrease in 1995 is due primarily to a return to more normal experience in comparison to the losses from the Northridge Earthquake, various airline losses and reinsurance costs in 1994, offset by additional Northridge Earthquake development in 1995. The Northridge Earthquake increased the loss ratio by 12.2% and 43.4% in 1995 and 1994, respectively.
Interest expense reflected during 1995 is due primarily to funds borrowed in 1994 to replace capital as a result of losses from the Northridge Earthquake.
Income Taxes. The income tax expense (benefit) for 1995 was $3.0 million, for 1994 was $(11.0) million and for 1993 $2.9 million. The effective tax rate for 1995, 1994 and 1993 was 19%, (35)% and 12%, respectively. The tax benefit in 1994 is attributable to the pre-tax loss. The benefit exceeds the Federal statutory income tax rate as the tax free municipal bond income and dividends received deduction exceeded slightly the non-deductible merger expenses, the increase in valuation
allowance attributable to the increase in the gross deferred tax asset, and taxation of Somerset Companies income. As a result of the Mergers with the Group, the Somerset Companies lost their S Corporation status effective June 30, 1994. This change in status from an S Corporation to a C Corporation resulted in an increase in the ongoing effective Federal, state and local tax rates and an immediate charge for Federal tax associated with accrued commissions at June 30, 1994 for which no Federal taxes had been provided.
In November 1988, the voters of the State of California approved Proposition 103, which required most property and casualty insurance companies, among other things, to reduce rates charged to California insureds to a level 20% below November 8, 1987 levels. On March 19, 1996, the Company agreed with the Commissioner to settle its rollback liability under Proposition 103. The Company expects to be able to recover some portion of this settlement from reinsurers. As a result of these recoveries and existing reserves, management does not believe this settlement will have a material adverse effect on the Company.
Cash flow from operations was $26.6 million, $5.3 million and $25.9 million for 1995, 1994 and 1993, respectively.
The Company was not in compliance with the NAIC's "Two-Year Overall Operating" ratio in 1995. The exceptional value derived from this ratio was primarily due to the underwriting losses resulting from the Northridge Earthquake. If the Two-Year Overall Operating ratio is 100% or more, the NAIC deems such results to be exceptional. During 1995, the Company's Two-Year Overall Operating ratio was 115%. The Company does not expect that this "unusual" value will have an effect on its operations.
The Company is a specialty insurance company and periods of moderate economic recession or inflation tend not to have a significant direct effect on the Company's underwriting operations. They do, however, impact the Company's investment portfolio. In 1995, interest rates declined and the Company's investment income was negatively impacted by lower yields. However, because the price of fixed maturity investments generally increase as interest rates decline, the market value of the Company's fixed maturity investments increased during this period.
In July 1993, the EITF reached consensus positions on EITF 93-6. The consensus position requires that the benefit or cost associated with additional consideration be recognized to the extent any consideration would be due to or from the reinsurer based on the contract experience to date. The amount of the asset or liability recognized must be computed as the difference between the total contract costs before and after the experience under the contract.
All debt and equity securities held by the Company are classified as Available-for-Sale Securities. The initial adoption of FASB Statement No. 115 increased the stockholder's equity by $4,609,808 on January 1, 1994.
In March 1995, the FASB issued Statement No. 121, "Accounting For the Impairment of Long- Lived Assets and for Long-Lived Assets to be Disposed of." The Statement establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets to be held and used and for long-lived assets and certain identifiable intangibles to be disposed of. The accounting requirements of Statement No. 121 are effective for the Company's 1996 financial statements. The Company does not expect the implementation of this standard to have a significant impact on its financial position or results.
The consolidated financial statements required in response to this section are submitted as part of Item 14(a) of this report.