Our New York underwriting office and certain executive offices are located at One Penn Plaza, New York, New York and occupied pursuant to a lease from an unaffiliated company which expires December 31, 2010. Several of our subsidiaries and branches have noncancellable operating leases for their respective office locations including Chicago, Houston, New Haven, San Francisco, Seattle, London and Antwerp.
(2)Calculated as stockholders' equity divided by actual shares outstanding as of the date indicated. 36 - A N N U A L R E P O R T 2 0 0 5
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. Our insurance company subsidiaries' 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 $120.0 million of the approximately $123.8 million in net proceeds we received from our October 2005 equity offering and we contributed $95.0 million of the approximately $110.8 million in net proceeds we received from our October 2003 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.
The discussions that follow include tables, which contain both our consolidated and segment operating results for each of the years in the three-year period ended December 31, 2005. In presenting our financial results we have discussed our performance with reference to underwriting results which is a non-GAAP measure and the related combined ratio which is another non-GAAP measure of underwriting profitability. We consider such measures, which may be defined differently by other companies, to be important in the understanding of our overall results of operations. Underwriting profit or loss is calculated from premiums earned, less net losses and LAE, commission expense and other operating expenses related to underwriting activities. The combined ratio is derived by taking such net losses and LAE and expenses divided by earned premiums. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.
Although not a financial measure, management's decisions are also greatly influenced by access to specialized underwriting and claims expertise in our lines of business. We have chosen to operate in specialty niches with certain common characteristics which we believe provide us with the opportunity to use our technical underwriting expertise in order to realize underwriting profit. As a result, we have focused on underserved markets for businesses characterized by higher severity and low frequency of loss where we believe our intellectual capital and financial strength bring meaningful value. In contrast, we have avoided niches that we believe have a high frequency of loss activity and/or are subject to a high level of regulatory coverage requirements, such as workers compensation and personal automobile insurance, because we do not believe our technical expertise is of as much value in these types of businesses. Examples of niches that have the characteristics we look for include bluewater hull (which provides coverage for physical damage to, for example, highly valued cruise ships) and directors and officers liability (which covers litigation exposure of a corporation's directors and officers). These types of exposures require substantial technical expertise. We attempt to mitigate the financial impact of severe claims on our results by conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.
Over the past three 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 substantial insurance industry losses resulting from Hurricanes Katrina and Rita in August and September of 2005, the marine insurance market is experiencing diminished capacity and rate increases, particularly for the Gulf of Mexico offshore energy line of business. Specialty liability losses, particularly from our California 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. Rates for the California construction liability business leveled off in the first six months and began to decline in the second half of 2005 after rate increases in 2004 and 2003. In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with recent 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. These conditions resulted in rate increases in 2002 and 2003 as well as an overall improvement in policy terms and conditions for our professional liability line of business. The professional liability renewal business written by the Company experienced low single digit premium rate decreases in 2004 and relatively level rates in 2005.
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The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We continually assess our concentration of underwriting exposures in catastrophe exposed areas globally and attempt to manage this exposure through individual risk selection and through the purchase of reinsurance. We also use modeling technologies and concentration management tools that allow us to better monitor and control our accumulations of potential losses from catastrophe exposures. Despite these efforts, there remains uncertainty about the characteristics, timing and extent of insured losses given the nature of catastrophes. The occurrence of one or more severe catastrophic events could have a material adverse effect on the Company's results of operations, financial condition or liquidity.
As a result of the offshore energy losses suffered by the marine and energy market in 2005 stemming from Hurricanes Katrina and Rita, the 2006 marine reinsurance capacity has declined, reinsurance terms and conditions have tightened and reinsurance costs have dramatically increased, particularly for excess of loss reinsurance protection. As a result, while the Company expects to achieve significant improvements in pricing, terms and conditions for the offshore energy business in 2006 and reduce its aggregate loss exposures in the Gulf of Mexico, it will have an increased net retention for a catastrophic offshore energy loss as a result of less available reinsurance protection at an increased reinsurance cost.
Hurricanes Katrina and Rita 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.
The impact of Hurricanes Katrina and Rita on our 2005 financial results follow:
On August 29, 2005, Hurricane Katrina struck Louisiana, Mississippi, Alabama and surrounding areas, causing significant destruction in those areas. Our estimate of after-tax net losses, inclusive of expected reinsurance recoveries and related reinsurance reinstatement premiums, is approximately $14.9 million or $1.10 per share for the 2005 year. Our estimate of net losses related to Hurricane Katrina was developed from a combination of preliminary claims notifications received from brokers and insureds, portfolio modeling based upon the storm track of Hurricane Katrina and the Company's own internal assessment of the exposures insured under individual policies. A substantial portion of the Company's estimated loss is due to offshore energy exposures in the Gulf of Mexico. Based upon management's estimate of ultimate loss, we believe that the Company's gross claims are contained within our reinsurance program. Our actual losses from Hurricane Katrina may differ materially from our estimated losses as a result of, among other things, the receipt of additional information from insureds or brokers, the attribution of losses to coverages that for the purpose of our estimates we assumed would not be exposed and inflation in repair costs due to the limited availability of labor and materials. If our actual losses from Hurricane Katrina are materially greater than our estimated losses, our business, results of operations and financial condition could be materially adversely affected.
Approximately 25% of the gross losses incurred for Hurricanes Katrina and Rita 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.
The insurance industry has become the subject of increasing scrutiny with respect to insurance broker and agent compensation arrangements and certain sales practices. During 2004, the New York State Attorney General and other state and federal regulators commenced investigations and other proceedings relating to the payment of contingent commissions by insurance companies to insurance brokers and agents and the extent to which such compensation has been disclosed, and the solicitation and provision of fictitious or inflated quotes. These investigations and proceedings could result in legal precedents and new industry-wide practices or legislation, rules or regulations that could significantly affect our industry and may also cause stock price volatility for companies in the insurance industry.
Reserves for Losses and LAE. Reserves for losses and LAE 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 original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results. Additional information regarding our loss reserves can be found in "-Results of Operations-Operating Expenses-Net Losses and Loss Adjustment Expenses Incurred," "Business-Reserves," and Note 6 to our consolidated audited financial statements, all of which are 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 7 to our consolidated audited financial statements, both included herein.
Impairment of Investment Securities. 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. 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. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost or amortized cost of the security, as appropriate, the length of time the investment has been below cost or amortized cost and by how much, 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 portfolio at December 31, 2005 and 2004, including disclosures regarding other-than-temporary declines in investment value, see the "Business-Investments" section and Note 2 to our consolidated audited financial statements, both included herein.
Accounting for Lloyd's Results. We record our pro rata share of Lloyd's Syndicate 1221 assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd's accounting to U.S. GAAP. The most significant 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 "RITC"). The RITC transaction is recorded in the fourth quarter 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 RITC transaction. Additional information regarding our accounting for Lloyd's results can be found in Note 1 to our consolidated audited financial statements, included herein.
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Cash flow from operations increased in 2005 and 2004 by approximately 46.9% and 20.8%, respectively, contributing to the growth in invested assets and net investment income. Investment income 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 yield. The growth in 2004 investment income of 37% compared to 2003 was due to the increase in invested assets. The 2004 investment income increase was somewhat mitigated in 2004 compared to 2003, as a result of the overall declines in interest rates in the investment portfolio and the broader financial market.
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 100.9% was negatively impacted by 10.5 points from Hurricanes Katrina and Rita while being reduced by 1.1 loss ratio points for a net redundancy of prior year loss reserves of $3.8 million.
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Specialty Premium. The 2005 business consists of 62% general liability business for small general and artisan contractors, 12% personal umbrella business, 12% excess casualty and 14% other targeted commercial risks. The 2005 gross written premium increased 40.3% when compared to 2004 reflecting growth across all lines of business and premiums generated from our excess casualty business, which started in the first quarter of 2005. During 2005 we 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. We also commenced writing first party personal lines warranty coverage on underground fuel tanks excluding pollution coverage. The specialty premium increased 14.4% in 2004 compared to 2003 due to increased rates and underwriting new policies. The average renewal rate changes in the contractors' liability business decreased approximately 1% in 2005 following increases of 13% and 49% in 2004 and 2003, respectively. During 2004 and 2003, the number of California construction liability in-force policies decreased significantly as a result of our efforts to scale back the number of small artisan policies we write. The new business and the rate increases resulted from a tightening market for California contractors' liability insurance.
Marine Premium. The 2005 business consists of 36% cargo and specie, 19% marine liability, 15% offshore energy, 9% assumed excess of loss on marine business, 5% hull, and the remainder in several other marine related classes of business. Our gross written premium is based on the amount of Syndicate 1221's stamp capacity that we provide. Our percentage of participation in the stamp capacity was 97.5% in 2005 compared to 97.4% in both 2004 and 2003. Stamp capacity is a measure of the amount of premium a Lloyd's syndicate is authorized to write as determined based on a business plan approved by the Council of Lloyd's. The Syndicate's stamp capacity was £135 million ($246 million), £150 million ($275 million) and £125 million ($204 million) in 2005, 2004 and 2003, respectively. The marine gross written premium decreased 10.2% in 2005 compared to 2004 and increased 21.5% in 2004 compared to 2003. In September 2005, the Company purchased the remaining outstanding minority interest and will own 100% of Syndicate 1221's stamp capacity for the 2006 underwriting year.
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The ratio of total ceded written premium to total gross written premium in 2005 was 51.2% compared to 55.1% for 2004 and 49.4% for 2003. The Insurance Companies' marine and Lloyd's Operations 2005 ceded written premium includes $9.1 million and $5.3 million, respectively, of reinstatement premium related to the losses from Hurricanes Katrina and Rita. 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.
The 2005 ceded written premium percentage was 62.1% for marine business, which includes 3.9 percentage points of ceded reinstatement premiums, compared to 62.3% for 2004 principally due to the Company's increased participation in the marine pool. The increase to 62.3% for 2004 marine business ceded premium, compared to 53.1% in 2003 reflects increased purchases of quota share reinsurance for certain marine classes of business, net reinstatement premium costs of $1.5 million for Hurricane Ivan losses which added 0.7 percentage points to the 2004 ceded written premium percentage and an overall increase in excess of loss reinsurance premium since 2002.
The 2005 percentage of ceded premium in our Lloyd's Operations decreased to 54.5%, or 53.4% when excluding the $5.3 million of reinstatement premium related to the losses from Hurricanes Katrina and Rita. The 2004 ceded premium amount for the Lloyd's Operations includes $47.6 million or 18.0% of Syndicate 1221 gross written premium in connection with the RITC transaction of which $22.2 million was assumed by Navigators Insurance Company through a retrocession of the Syndicate's reinsurance.
Net Written Premium. The 2005 net written premium increased 21.7% while 2005 gross written premium increased 12.0% reflecting increased premium writings coupled with retaining more of the business written due to the reductions in ceded reinsurance premiums discussed above. The 2004 net written premium increased 1.8% while 2004 gross written premium increased 14.8% reflecting the effects of the 2004 RITC transaction and the 2004 reinsurance ceded changes discussed above. The 2003 net written premium contains $13.9 million in connection with a commutation with a former pool member which is recorded as a reduction in 2003 ceded reinsurance premium compared to 2004 when no such transaction occurred.
Net Earned Premium. Net earned premium increased 8.9% in 2005 compared to 2004, 12.0% in 2004 compared to 2003 and 25.0% in 2003 compared to 2002. The 2005 net earned premium was reduced by $14.5 million of reinstatement premium as discussed above. The 2005 and 2004 net earned premium include $2.5 million and $12.8 million, respectively, as a result of the RITC transactions, while the 2003 earned premium amount contains $11.0 million in connection with the commutation with a former marine pool member.
Net Realized Capital Gains. Pre-tax net income included $1.2 million of net realized capital gains for 2005 compared to $0.9 million for 2004 and $1.9 million for 2003. On an after-tax basis, the net realized capital gains were $0.8 million or $0.06 per share, $0.6 million or $0.05 per share and $1.2 million or $0.13 per share for 2005, 2004 and 2003, respectively.
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The provision for loss adjustment expenses includes defense cost containment expenses for outside adjustors, attorneys' fees and internal operating expenses consisting principally of claims department costs incurred in the processing and settlement of claims. Commencing in 2005, the Company allocated paid claims department costs in losses incurred while previously such payments were included in other operating expenses. Such payments included in incurred losses for the 2005 year were $4.9 million compared to $3.0 million and $2.8 million for 2004 and 2003, respectively included in other operating expenses. Such reclassifications have no impact on net income and the combined loss and expense ratios for all current and prior periods.
The following table sets forth our net loss reserves by segment and line of insurance business and the total case reserves and IBNR as of the date indicated:
At December, 2005, the IBNR loss reserve was $350.6 million or 60.5% of our total loss reserves compared to 59.1% in 2004 and 58.7% 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 three years. The 2005 marine net loss reserve increase for both the Insurance Companies and Lloyd's Operations also increased due to loss reserves established for Hurricanes Katrina and Rita. The increase in marine net loss reserves for the Lloyd's Operations also contains loss reserves assumed from reinsurers and the Insurance Companies in connection with the 2005 RITC transaction.
The increase in gross incurred losses on the Company's 2005 and 2004 balance sheets primarily relates to incurred losses for events occurring in 2005 and 2004. Approximately 80% of the 2005 increase in the gross loss reserves and 91% of the 2005 increase in reinsurance recoverables relate to Hurricanes Katrina and Rita. With the recording of gross losses, the Company assesses its reinsurance coverage, potential receivables, and the recoverability of the receivables. Losses incurred on business recently written are primarily covered by reinsurance agreements written by companies with whom the Company is currently doing reinsurance business and whose credit the Company continues to assess in the normal course of business.
As discussed below and under the caption "Business-Loss Reserves," there are a number of factors that could cause actual losses and loss adjustment expenses to differ materially from the amount that we have reserved for losses and loss adjustment expenses.
The process of establishing loss reserves is complex and imprecise as it must take into account many variables that are subject to the outcome of future events. As a result, informed subjective judgments as to our ultimate exposure to losses are an integral component of our loss reserving process.
For certain long tail classes of business where anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns, estimates are based on both expected losses and actual reported losses. These classes include our California contractors liability business and directors and officers liability business, among others. For these classes, we set ultimate losses for each underwriting year reflecting several factors, including our evaluation of loss trends and the current risk environment. The expected ultimate losses are adjusted as the underwriting year matures.
While we have a significant amount of loss development data that is utilized by our actuaries to establish the IBNR loss reserves for our California 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 litigation to obtain defect repairs. The legislation and its potential impact is discussed in the "Business-Loss Reserves" section included herein. Accordingly, our ultimate liability may exceed or be less than current estimates due to this variable, among others.
The professional liability business generates third-party claims which also are longer tail in nature. The professional liability policies mostly provide coverage on a claims-made basis, whereby coverage is generally provided only for those claims that are made during the policy period. These claims often involve a lengthy litigation period after being reported. Our professional liability business is relatively immature, as we first began writing the business in late 2001. Accordingly, it will take some time to better understand the reserve trends on this business. Given the limited history of this business, the actuaries generally utilize industry data to initially establish IBNR loss reserves, which are subsequently adjusted based on actual and expected claim emergence as each underwriting year matures.
At the start of each underwriting year, our actuaries and management determine an initial selected ultimate loss ratio for each line of business. Management participation generally includes the underwriter for the particular line of business, executive management, and claims and finance personnel. Generally, such determinations are based on prior year history modified where deemed appropriate for observed changes in premium rates, terms, conditions, exposures, and loss trends. Industry data is generally utilized for new lines of business.
The Company has historically reserved for the professional liability business using ultimate loss ratios based on industry experience for this new line of business written since 2001. 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 $1.6 million of prior year savings from business assumed from the Lloyd's Operations principally related to the 2003 underwriting year where loss reserves reductions were related to the reductions in premium estimates.
The Company recorded $800,000 of prior year savings for run-off business principally due to favorable loss experience on aviation business discontinued in 1999.
The Company recorded a prior year reserve deficiency of $1.9 million for marine business principally due to an increase of approximately $4.5 million for unallocated loss adjustment expense reserves offset by net favorable loss experience of $2.6 million mostly related to the 2002 and prior underwriting years.
Included in the 2004 incurred losses for specialty business was a series of claims aggregating to approximately $2 million, from a single 2002 underwriting year policy that were all below the $150,000 attachment point of our 2002 year reinsurance program. Such unusual loss activity was the primary reason for the $2.3 million of prior year loss deficiency recorded in 2004 for specialty business.
As discussed above, the Company has historically reserved for the professional liability business using ultimate loss ratios based on industry experience for this relatively new line of business. During the 2004 fourth quarter, the loss reserves for such claims-made policies for underwriting years 2003 and 2002 were reduced by approximately $2.8 million to recognize the low level of claim counts and favorable claims development compared to expectations at the time these reserves were initially established which were based on industry data.
Following is a discussion of relevant factors impacting our 2003 loss reserves.
During 2003, the Insurance Companies recorded for marine business adverse loss development approximating $9 million for underwriting years 2000 to 2002 principally related to underestimates of loss reserves established for such periods. Offsetting such loss development were prior year savings of approximately $4 million for underwriting years 1997 and 1996 due to the combination of favorable loss development and the reduction of tail factors and an additional net redundancy of $1 million for all other underwriting years. The tail factors were reduced in recognition that salvage and subrogation recoveries tend to
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Incurred losses for specialty business included $22.2 million of prior year reserve deficiencies due to adverse loss development and the lengthening of tail factors for underwriting years 1995 to 2000. Substantially all of the reserve deficiencies related to the California contractors' liability business, which has a long tail for the reporting and settlement of construction defect claims.
The Company recorded $2.8 million of prior year reserve deficiencies for run-off business, mostly in the first half of 2003. Such loss development was principally related to assumed reinsurance business discontinued in 1999.
As discussed under "Business-Loss Reserves" gross and net loss reserves were increased in the 2003 fourth quarter by $77.6 million and $31.6 million, respectively, as a result of a review of asbestos exposures conducted by the Company. The $31.6 million of net asbestos losses includes $25.7 million of uncollectible reinsurance. For the full year, the prior year loss reserve deficiency for asbestos and environmental exposures was $32.5 million.
Partially offsetting such prior year reserve deficiencies in 2003 was $2.8 million of prior year savings from our Lloyd's Operations principally from the 2002 and 2001 underwriting years reflecting favorable loss development.
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 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.
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:
Marine reserves for the Insurance Companies are established by product using the Company's own historical experience adjusted for the effects of current developments and likely trends. Estimates of the ultimate liability could be redundant or deficient if the Company's own experience is not appropriate for predicting future outcomes. For example, this could occur if claims take longer to report than expected. Gross and net losses would increase by approximately $37.9 million and $16.0 million, respectively, if, on average, losses take 10% longer to report than assumed for the marine business for reserves established at December 31, 2005.
Given the lack of sufficient historical experience, professional liability reserves are established using industry loss ratios and development patterns. The ultimate loss ratio for an underwriting year is initially set to an industry average level. Expected loss emergence is then calculated using industry average development patterns, and expected emergence is replaced by actual experience as it emerges. Estimates of ultimate liability could be redundant or deficient if the industry selected ultimate loss ratios are inappropriate or if the industry development pattern is not representative of our book of business. If the ultimate loss ratios for the professional liability business develop 10% higher than the industry ultimate loss ratios used by our actuaries, then gross and net loss reserves would increase by approximately $9.7 million and $3.7 million, respectively, compared to the professional liability loss reserves established at December 31, 2005.
Interest Expense. The loan balance was paid in October 2003 from a portion of the proceeds from the Company's common stock offering, therefore no interest expense was recorded in 2005 or 2004.
Income Taxes. The income tax expense (benefit) was $10.2 million, $17.2 million and $(4.9) million for 2005, 2004 and 2003, respectively. The effective tax rates for 2005, 2004 and 2003 were 30.2%, 33.1% and (175.3%), respectively. The Company's effective tax rate is less than 35% due to permanent differences between book and tax return income, the most significant item is tax exempt interest. As of December 31, 2005 and 2004, the net deferred Federal, foreign, state and local tax assets were $28.3 million and $17.3 million, respectively.
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We are subject to the tax regulations of the United States and foreign countries in which we operate. The Company files a consolidated federal tax return, which includes all domestic subsidiaries and the U.K. Branch. The income from the foreign operations is designated as either U.S connected income and non-U.S. connected income. Lloyd's is required to pay U.S. income tax on U.S. connected income (U.S. source income) written by Lloyd's syndicates. Lloyd's and the IRS have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd's and remitted directly to the IRS. These amounts are then charged to the corporate members in proportion to their participation in the relevant syndicates. The Company's corporate members are subject to this agreement and will receive U.K. tax credits for any U.S. income tax incurred up to the U.K. income tax charge on the U.S. income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the Internal Revenue Code since less than 50% of the Company's premium is derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd's year of account closes. Taxes are accrued at a 35% rate on our foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. U.S. taxes are not accrued on the earnings of the Company's foreign agencies as these earnings are not subject to the Subpart F tax regulations. These earnings are subject to taxes under U.K. tax regulations at a 30% rate.
The Insurance Companies' and the Lloyd's Operations' results are measured by taking into account net premiums earned, incurred losses and loss adjustment expenses, commission expense and other underwriting expenses. The Navigators Agencies' results include commission income less other operating expenses. Results of the Parent and Other Operations include inter-segment income and expense in the form of affiliated commissions, income and expense from corporate operations and consolidating adjustments. Each segment also maintains its own investments, on which it earns income and realizes capital gains or losses.
The 2005 underwriting results were favorably impacted by approximately $2.6 million or 1.1 loss ratio points for net prior year savings of which $3.0 million was for professional liability business, $1.6 million for business assumed from our Lloyd's Operations and $0.8 million for run-off business, partially offset by deficiencies of $1.9 million for marine business and $0.9 million for specialty business.
The 2004 underwriting results benefited from improved market conditions since 2002 across all lines of business as reflected in the 92.4% combined ratio. The 2004 underwriting results were negatively impacted by approximately $2.8 million or 1.2 loss ratio points for net prior year loss development of which $4.8 million was for marine business, $2.3 million for specialty business and $0.7 million for run-off business, offset by $2.8 million of prior year savings for professional liability business and $2.2 million from business assumed from our Lloyd's operations. The net loss to the Insurance Companies from Hurricane Ivan of approximately $3.1 million increased the 2004 marine combined ratio by 3.7 ratio points and the Insurance Companies' combined ratio by 1.3 ratio points.
The pre-tax yield on the Insurance Companies' investment portfolio approximated 4.3%, 4.0% and 4.3% for 2005, 2004 and 2003, respectively. The increase in the 2005 yield was primarily due to the investment of new funds, including the $120 million
statutory surplus contribution from the net proceeds from our October 2005 equity offering, in an environment of gradually increasing interest rates as monetary policy tightened throughout the year. Average yields in the Company's investments declined during 2004 and 2003 primarily as the result of market yields decreasing through the first half of 2003 and then gradually increasing as monetary policy began to tighten. During this period, the strong cash flow and the $95 million statutory surplus contribution from the net proceeds from the Company's October 2003 stock offering were being invested. Due to the lag between receiving funds and investing long term, short-term balances increased each year. Secondarily, the Company's investment strategy began to lean towards tax-exempt securities as the Company was exiting an AMT carry forward position. Generally, short term investments and tax exempt securities have lower pre-tax yields than the remainder of the Company's portfolio. These factors along with the reinvestment of maturities, calls and redemptions at the then prevailing interest rates, which were generally lower than the yields of such investments maturing, called or redeemed, resulted in decreases to the overall portfolio yield, but in-line with prevailing interest rates based on our portfolio mix. Net investment income increased in 2004 compared to 2003 despite declines in the average investment yield on the portfolio due to strong cash flows throughout 2004 and 2003 coupled with the receipt of $95 million of statutory surplus contributions in the 2003 fourth quarter.
Our Lloyd's Syndicate 1221's stamp capacity was £135 million ($246 million) in 2005, £150 million ($275 million) in 2004 and £125 million ($204 million) in 2003. The stamp capacity for 2005 was reduced to £135 million ($246 million) reflective of unused stamp capacity in 2004 coupled with anticipated declining market conditions in 2005. Stamp capacity is a measure of the amount of premium a Lloyd's syndicate is authorized to write as determined by the Council of Lloyd's. Syndicate 1221's stamp capacity is expressed net of commission (as is standard at Lloyd's) of approximately 21%. The Syndicate 1221 premium recorded in our financial statements is gross of commission. We provided 97.5%, 97.4% and 97.4% of Syndicate 1221's total capacity for the 2005, 2004 and 2003 underwriting years, respectively. In 2003, we reinsured 15.4% of our Syndicate 1221 capacity through the utilization of quota share reinsurance agreements to third parties who provide letters of credit used as collateral at Lloyd's. The Lloyd's marine business had been subject to deteriorating pricing beginning in the mid-1990's. The pricing competition showed some signs of stabilizing in 2000 and prices increased in 2001, 2002 and 2003. The 2004 pricing stayed relatively stable and 2005 increased by approximately 2.8%. 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. In September 2005, the Company purchased the remaining outstanding minority interest and will own 100% of Syndicate 1221's capacity for the 2006 underwriting year.
Lloyd's syndicates report the amounts of premiums, claims, and expenses recorded in an underwriting account for a particular year to the companies or individuals that participate in the syndicates. The syndicates generally keep accounts open for three years. Traditionally, three years have been necessary to report substantially all premiums associated with an underwriting year and to report most related claims, although claims may remain unsettled after the underwriting year is closed. A Lloyd's syndicate typically closes an underwriting year by reinsuring outstanding claims on that underwriting year with the participants for the next underwriting year. The ceding participants pay the assuming participants an amount based on the unearned premiums and outstanding claims in the underwriting year at the date of the assumption. Our participation in Lloyd's Syndicate 1221 is represented by and recorded as our proportionate share of the underlying assets and liabilities and results of operations of the syndicate, since (i) we hold an undivided interest in each asset, (ii) we are proportionately liable for each liability and (iii) Syndicate 1221 is not a separate legal entity. At Lloyd's, the amount to close an underwriting year into the next year is referred to as the reinsurance to close (the "RITC"). The RITC amounts represent the transfer of the assets and liabilities from the participants of a closing underwriting year to the participants of the next underwriting year. To the extent our participation in the syndicate changes, the RITC amounts vary accordingly. The RITC transaction is recorded in the fourth quarter as additional written and earned premium, losses incurred, loss reserves and receivables, all in the same amount. There were no gains or losses recorded on the RITC transaction.
Wherever 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 Company's 2005 capacity at Lloyd's of £135 million, the December 31, 2005 exchange rate of £1 equals $1.72 and in the event of a maximum 3% assessment, the Company would be assessed approximately $7 million.
Following are the results of operations of the Lloyd's Operations for each of the years in the three-year period ended December 31, 2005:
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Approximately 43% of the gross losses incurred for Hurricanes Katrina and Rita were generated from assumed excess of loss marine reinsurance, a substantial portion of which was retroceded. A large portion of this assumed reinsurance was not renewed during 2006.
The 2005 underwriting results were favorably impacted by approximately $1.2 million or 1.1 loss ratio points for net prior year savings.
The 2005 net earned premium and incurred losses were increased by $2.5 million as a result of the RITC transaction for the 2003 year of account. The 2004 net earned premium and incurred losses were increased by $12.8 million as a result of the RITC transaction for the 2002 year of account. The RITC recorded in 2004 when compared to 2003 reflects the increase in our participation in Lloyd's Syndicate 1221 to 97.4% for the 2003 year of account from 68.1% for the 2002 year of account. Two participants in Lloyd's Syndicate 1221 for the 2002 year of account changed their status for the 2003 year of account from participants to reinsurers. Upon closing the 2002 year of account at the end of 2004, substantially all of the RITC assumed on a gross basis for the 2002 year of account was ceded to these reinsurers for the 2003 year of account. One of these reinsurers ceded
(1)Participation after reinsurance of Navigators' corporate capital vehicles, but before other third party reinsurance For 2006, Syndicate 1221's stamp capacity was reduced to £112.5 million ($193 million) and our participation is 100%, while the cessions similar to the cessions to the reinsurers referenced above will be 10%.
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interest rates during 2005. Lloyd's average duration of 1.4 years at December 31, 2004 as compared to 1.3 years at December 31, 2005.
The Navigators Agencies produce business for our insurance company subsidiaries. They specialize in writing marine and related lines of business, specialty liability insurance and professional liability coverages.
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Following are the results of the Navigators Agencies for each of the years in the three-year period ended December 31, 2005:
Other operating expenses consist 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 expenses have increased each year commensurate with servicing the growth in the overall premium volume coupled with the increased costs incurred in 2005 and 2004 to comply with Section 404 of the Sarbanes-Oxley Act of 2002.
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The following table sets forth our known contractual obligations with respect to the items indicated at December 31, 2005:
Investments and cash increased to $1,182.2 million at December 31, 2005 from $854.9 million at December 31, 2004 and $693.6 million at December 31, 2003. The increases were primarily due to the positive cash flow, $123.8 million of net proceeds received from the equity offering in October 2005 and the $110.8 million of net proceeds received from the equity offering in October 2003. Net investment income was $37.1 million for 2005, $26.8 million for 2004 and $19.6 million for 2003.
We have a $125 million credit facility with a consortium of banks consisting of $115 million for letters of credit and a $10 million credit line. The credit facility, which is denominated in U.S. dollars, is utilized primarily by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. to fund our participation in Lloyd's Syndicate 1221 which is denominated in British pounds. At December 31, 2005, letters of credit with an aggregate face amount of $75.9 million were issued under the credit facility. The credit line is unused at December 31, 2005.
The credit facility expires on June 30, 2007. If at that time the banks do not renew the credit 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.
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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 2005, 2004 and 2003, approximately 73%, 58% and 51%, respectively of gross incurred losses of approximately $886 million, $453 million and $427 million, respectively, were ceded to reinsurers under pro-rata and quota share treaties. 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 reinsurers, including pool participants, the Company issues quarterly settlement statements for premiums less commissions and paid loss activity, which are expected to be settled within 45 days after the quarter end. The Company has the ability to issue "cash calls" requiring such reinsurers to pay losses whenever paid loss activity ceded to a particular reinsurance treaty exceeds a predetermined amount (generally not more than $1 million) as set forth in the pro-rata treaty. For the Insurance Companies, cash calls must generally be paid within 15 business days. There is no specific settlement period for the Lloyd's Operations cash call provisions but such billings are generally paid within 30 days.
The Company sometimes withholds funds from reinsurers and may apply ceded loss billings against such funds in accordance with the applicable reinsurance agreements.
At December 31, 2005, approximately $26.5 million was due from reinsurers under pro rata and excess of loss reinsurance treaties in connection with our asbestos exposures of which $15.4 million is due from Equitas. Approximately 80% of such amounts will be due and payable to the Company over the next two years as the gross asbestos losses are billed and paid by the Company. The Company generally experiences significant collection delays for a large portion of such balances 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.
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