In the second quarter of 2003, we elected to lease additional space in Rye Brook, New York, from an unaffiliated company. Rye Brook is approximately 30 miles north of Manhattan. Our administrative, accounting and information technology staffs and certain executive offices are now located at our Rye Brook, New York office. Our lease for this space terminates in February 2013.
(2)Calculated as stockholders' equity divided by actual shares outstanding as of the date indicated.
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The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Please see "Note on Forward-Looking Statements" for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K.
We are an international insurance holding company focusing on specialty products for niches within the overall property/casualty insurance market. 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 which primarily consists of contractors' liability coverages. We conduct operations through our insurance company subsidiaries, the Navigators Agencies and our Lloyd's operations.
Our revenue is primarily comprised of premiums, commission and investment income. Our insurance company subsidiaries derive their premiums primarily from business written by the Navigators Agencies. The Lloyd's operations derive their premiums from business written by NUAL. The Navigators Agencies and NUAL receive commissions and, in some cases, profit commissions and service fees on the business produced on behalf of our insurance company subsidiaries and others.
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 period being reported upon. 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.
Our most critical accounting policies involve the reporting of the reserves for losses and loss adjustment expenses (including losses that have occurred but were not reported to us by the financial reporting date), reinsurance recoverables, written and unearned premium, the recoverability of deferred tax assets, the impairment of invested assets, accounting for Lloyd's results, goodwill and the translation of foreign currencies..
Loss Reserves and Loss Adjustment Expenses. Loss reserves represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may be different from the
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. See Note 1 to our consolidated audited financial statements, included herein.
Deferred Tax Assets. We have recorded valuation allowances related to deferred tax assets resulting from certain net operating loss carryforwards due to the uncertainty associated with the realization of the deferred tax asset related to certain of our foreign, state and local operations. Our foreign operations were profitable in 2002 and 2003 resulting in a portion of the valuation allowance being simultaneously released to the extent of the 2002 profits and the first nine months of profits in 2003. Due to the continued profitability and projected favorable market conditions for the foreseeable future, it was determined to be more likely than not that the deferred tax assets resulting from those net operating loss carryforwards will be realized, therefore the remaining valuation allowance related to the foreign operations was released in the fourth quarter of 2003. See Note 5 to our consolidated audited financial statements, included herein.
Impairment of Invested Assets. Impairment of investment securities results in a charge to operations when a market decline below cost is other-than-temporary. Management regularly reviews our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to: the current fair value as compared to cost or amortized cost, as appropriate, of the security; the length of time the security's fair value has been below cost or amortized cost, and by how much; and specific credit issues related to the issuer and current economic conditions. In general, we focus our attention on those securities whose market value was less than 80% of their cost or amortized cost, as appropriate, for six or more consecutive months. Other factors considered in evaluating potential impairment include the current fair value as compared to cost or amortized cost, as appropriate, our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements. For additional detail regarding our investment
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Accounting for Lloyd's Results. We record our pro rata share of Lloyd's syndicate assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd's accounting to U.S. generally accepted accounting principles, or GAAP. The most significant U.S. GAAP adjustments relate to income recognition. Lloyd's syndicates determine underwriting results by year of account at the end of three years. We record adjustments to recognize underwriting results as incurred, including the expected ultimate cost of losses incurred. These adjustments to losses are based on actuarial analysis of syndicate accounts, including forecasts of expected ultimate losses provided by the syndicate. At the end of the Lloyd's three-year period for determining underwriting results for an account year, the syndicate will close the account year by reinsuring outstanding claims on that account year with the participants for the account's next underwriting year. The amount to close an underwriting year into the next year is referred to as the "reinsurance to close." The reinsurance to close transactions are recorded as additional written and earned premium, losses incurred, loss reserves and receivables, all in the same amount. There are no gains or losses recorded on the reinsurance to close transactions. See Note 1 to our consolidated audited financial statements, included herein.
Goodwill. The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") 142, "Goodwill and Other Intangible Assets," effective January 1, 2002. SFAS 142 changes the accounting for goodwill and intangible assets that have indefinite useful lives from an amortization approach to an impairment-only approach that requires that those assets be tested at least annually for impairment. We completed our annual impairment review of goodwill resulting in no impairment as of January 1, 2003. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss will be recognized. See Note 1 to our consolidated audited financial statements, included herein.
The following is a discussion and analysis of our consolidated and segment results of operations for the years ended December 31, 2003, 2002 and 2001.
Our 2003, 2002 and 2001 results of operations reflect increasing premium rates as a result of improved market conditions beginning in late 2000 and continuing through 2003. Net income for 2003, 2002 and 2001 was $7.7 million or $0.80 per share, $16.4 million or $1.89 per share and $3.7 million or $0.43 per share, respectively.
Cash flow from operations has also increased in 2003 and 2002 by approximately 24.0% and 162.8%, respectively, contributing to the growth in invested assets and net investment income. The growth in investment income has been mitigated
Revenues. Gross written premium increased to $606.5 million in 2003 from $447.8 million in 2002 and $278.2 million in 2001. 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 2003 and 2002 marine premium increased 9.6% and 65.5%, respectively, due to the increase in premium rates resulting in higher premiums on new and renewal business. The generally improved pricing environment resulted in Navigators Insurance Company increasing its writing of new business which was partially offset in 2003 by a reduction of business in certain specific areas due to pricing concerns. The increased premium in 2003 of $17.2 million, which is net of business that was not renewed, includes approximately $13.8 million of premium resulting from rate increases which averaged 13%. The increased premium in 2002 of $70.9 million resulted from $49.2 million of new business and $20.9 million from rate increases which averaged 21%. 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 80% in 2003 and 75% in 2002 and 2001.
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Professional Liability Insurance. In late 2001, our insurance company subsidiaries began to write professional liability insurance, primarily consisting of directors and officers liability insurance for privately held and publicly traded corporations. In 2002, the professional liability business was expanded to include errors and omissions insurance and employment practices liability coverages. The professional liability premium increased to $53.0 million in 2003 from $23.4 million in 2002 reflecting growth and the expansion of this business.
Assumed from Lloyd's Operations. Since 2002, the Insurance Companies have participated in quota share treaties on marine and energy business written by the Company's Lloyd's operations.
Marine Premium. Marine premium increased 63.2% in 2003 and 10.1% in 2002 partially due to the increase in premium rates resulting in higher premiums on renewal and new business and due to the increased capacity provided to Syndicate 1221 by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. increasing from 67.4% in 2001 to 68.1% in 2002 to 97.4% in 2003. The higher premium rates, averaging approximately 15% in 2003 and 26% in 2002, made the business more attractive resulting in the Lloyd's operations increasing its writings of new business.
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 our insurance company subsidiaries or the Lloyd's operations. There are several factors contributing to an increase in ceded premium when comparing 2003 to 2002. First, rate increases on our business resulted in higher premium levels, and consequently more ceded premiums. The second factor is the cost of excess of loss reinsurance purchased to limit our exposure to an individual large loss. This increased reinsurance costs in the marine and specialty liability business. Effective from April 1, 2003 to September 30, 2003, the reinsurance treaty for our specialty liability business was amended to incorporate a ceding commission from the reinsurer and a rate increase. Third, we increased the amount of quota share reinsurance for certain product lines based upon management's assessment of expected loss activity. Fourth, Navigators Pro experienced substantial premium growth, resulting in increased amounts of premium ceded to its quota share reinsurance program. Additionally, we entered into quota share reinsurance agreements to reinsure 15.4% of our Syndicate 1221 capacity to third parties who provide letters of credit used as collateral at Lloyd's.
the gross written premium partially offset by the increase in the percentage of ceded premium from 38.0% in 2001 to 39.5% in 2002.
Net Earned Premium. Net earned premium increased 25.0% in 2003 compared to 2002 and increased 47.8% in 2002 compared to 2001 as a result of rate increases and new business generated in 2003 and 2002, and for 2003, the increase in the participation in the marine pool from 75% in 2002 to 80% in 2003.
The increase in net loss reserves in all active lines of business is generally a reflection of the growth in premium volume over the last two years. The net loss reserve increase for 2003 also includes an increase in reserves to $33.2 million from $1.5 million for asbestos and environmental exposures in the marine and run-off business as well as prior year loss reserve strengthening of approximately $22.2 million in our Specialty business related to the California contractors liability business. Approximately $31.8 million of the increase in asbestos and environmental reserves is recorded in marine and $1.4 million in other, primarily related to run-off aviation business.
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Included in 2003 and 2002 were tax benefits related to the reversal of a tax valuation allowance related to the Company's foreign operations of $5,284,000 and $1,267,000, respectively.
The Company had a valuation allowance of $4,529,000 as of the year ended December 31, 2002 due to the uncertainty associated with the realization of the deferred tax asset for the carryforward of operating losses from the Company's foreign operations. The Company's foreign operations were profitable in 2002 and 2003 resulting in a portion of the valuation allowance being simultaneously released to the extent of the 2002 profits and the first nine months of profits in 2003. Due to the continued profitability and projected favorable market conditions for the foreseeable future, it was determined to be more likely than not that the deferred tax assets resulting from those net operating loss carryforwards will be realized, therefore the remaining valuation allowance related to the foreign operations was released in the fourth quarter of 2003.
The Company also had net state and local operating loss carryforwards amounting to potential future tax benefits of $3,274,000 and $2,147,000 at December 31, 2003 and 2002, 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 carryforwards at December 31, 2003 expire from 2019 to 2023.
Our two insurance companies are Navigators Insurance Company, which includes a United Kingdom branch, and NIC Insurance Company. Navigators Insurance Company is our largest insurance subsidiary and has been active since 1983. It specializes principally in underwriting marine insurance and related lines of business, specialty liability insurance and professional liability insurance. NIC Insurance Company, a wholly owned subsidiary of Navigators Insurance Company, began operations in 1990. It underwrites similar types of business but on a non-admitted or surplus lines basis and is fully reinsured by Navigators Insurance. The Navigators Agencies produce business for our insurance company subsidiaries.
The Insurance Companies experienced rapid premium growth in all three lines of business as reflected in the net earned premium increases of 40.3% and 100.3% in 2003 and 2002, respectively. Approximately 10.3% and 3.7% of the net premium
recorded in 2003 and 2002 is a result of the Insurance Companies participating on reinsurance treaties supporting the Lloyd's Operations' marine and energy business.
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We provide letters of credit to Lloyd's to support our participation in Syndicate 1221's capacity. If we increase our participation, or if Lloyd's changes the capital requirements, we may be required to supply additional letters of credit or other collateral acceptable to Lloyd's, or reduce the capacity of Syndicate 1221. The letters of credit are provided through the credit facility which we maintain with a consortium of banks. The credit facility agreement requires that the banks vote by November 19th of each year whether or not to renew the letter of credit facility. If the banks decide not to renew the letter of credit facility, we will need to find other sources to provide the letters of credit or other collateral in order to continue to participate in Syndicate 1221. The renewal amendment executed in November 2003 renewed the letter of credit facility for a two year period expiring in November 2005.
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Underwriting results in 2003 were favorably impacted by $2.8 million for prior year reserve savings compared to $0.3 million and $9.9 million of prior year deficiencies recorded in 2002 and 2001, respectively. The 2001 deficiency was due to an increase in premium estimates and related reserves and strengthening of reserves for the 1999 underwriting year. The 2001 underwriting results were also adversely impacted by $4.5 million of pre-tax and after-tax losses related to the World Trade Center terrorist attack.
The pre-tax yields on funds at Lloyd's approximated 2.0%, 3.8% and 5.7% for 2003, 2002 and 2001, respectively, which are reflective of the declining interest rate environment since 2001. Generally, funds invested at Lloyd's have been invested with an average duration of approximately 1.4 years in order to meet liquidity needs.
The provision for income tax expense for 2003 and 2002 reflect the reversal of a previously established deferred tax asset valuation allowance. The valuation allowance was reversed up until the fourth quarter of 2003 only to the extent of taxable
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profits. The remaining valuation allowance was completely reversed in the 2003 fourth quarter since it was determined that it was more likely than not that the remaining deferred tax asset resulting from net operating loss carryforwards will be realized.
Other operating costs consists of compensation and general and administrative expenses incurred in connection with underwriting, administrative and claims services performed on behalf of the Insurance Companies and unaffiliated insurers participating in the marine pool. Such costs have been increasing each year commensurate with servicing the growth in the overall increased premium volume that has been generated in 2003 and 2002 for the Insurance Companies and unaffiliated members of the marine pool.
The following table sets forth our known contractual obligations with respect to the items indicated at December 31, 2003.
Invested assets and cash increased to $693.6 million at December 31, 2003 from $452.9 million at December 31, 2002 and $333.1 million at December 31, 2001. The increases were primarily due to the positive cash flow and the $110.8 million of net
proceeds received from the secondary public stock offering in October 2003. Net investment income was $19.6 million for the year ended December 31, 2003, $18.1 million for the year ended December 31, 2002 and $19.4 million for the year ended December 31, 2001.
The average yield of the portfolio, excluding net realized capital gains, was 3.79% in 2003, 4.78% in 2002 and 6.14% in 2001 reflecting the prevailing interest rates during those years. As of December 31, 2003 and 2002, all fixed maturity securities and equity securities held by us were classified as available-for-sale.
We have a credit facility provided through a consortium of banks. The credit facility provides for an $80.0 million letter of credit facility which was increased from $55.0 million in November 2003. The credit facility also provided for a $9.0 million line of credit facility which was fully utilized prior to the October 2003 common stock offering. As required by the credit facility agreement, the line of credit was fully paid from a portion of the proceeds from the common stock offering thereby eliminating the line of credit portion of the credit facility. The letter of credit facility is utilized primarily by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. for our participation in Lloyd's Syndicate 1221. The credit facility agreement requires that the banks vote by November 19th of each year whether or not to renew the letter of credit portion of the facility. If the banks decide not to renew the letter of credit portion of the facility, we will need to find other sources to provide the letters of credit or other collateral in order to continue our participation in Syndicate 1221. The renewal amendment executed in November 2003 renewed the letter of credit facility for a two year period. At December 31, 2003, letters of credit with an aggregate face amount of $77.6 million were issued under the letter of credit facility.
At December 31, 2003, our consolidated stockholders' equity was $290.0 million compared to $171.3 million at December 31, 2002. The increase was primarily due to the common stock offering and, to a lesser extent, the net income for the year ended December 31, 2003.
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We primarily rely upon dividends from our subsidiaries to meet our holding company obligations. The dividends have historically come primarily from Navigators Insurance Company. At December 31, 2003, the maximum amount available for the payment of dividends by Navigators Insurance Company during 2004 without prior regulatory approval was $21,032,000. During 2003, 2002 and 2001, Navigators Insurance Company paid dividends to us of $6,000,000, $6,500,000 and $11,000,000, respectively.